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Dividend discount model - using dividends to value stocks | Part 2: sustainable growth (Excel)(SUB) - YouTube
Channel: NEDL
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Hello everyone, and welcome to NEDL!
My name is Savva and today we're going to
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continue our journey down the dividend
discount model, a valuation technique
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that uses dividends to value stocks. Last
time, when we were talking about
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historical growth rates, we encountered a
very very interesting problem. For some
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stocks, in our case Intel Corp, the
historical dividend growth rate was
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higher than the required rate of return,
and thus, the dividend discount model,
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the logic of discounted cash flows,
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was inapplicable as one of the assumptions
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that the discounted cash flows formula
makes, is that the series of discounted
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cash flows are convergent, that is the
discounted cash flows decrease over time
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In the case when the historical growth rate
or growth rates, in general, is higher than
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the required rate of return, then the cash
flows increase at a higher rate than
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they are discounted, so the series does
not have a finite sum, so the model thus
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is inapplicable. How to deal with this
issue? Well, one of the assumptions that
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we can make further on, is that the
historical growth rate that we observe
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in case of companies like Intel Corp or
even Royal Dutch Shell when average
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historical growth rates are very very
high or unstable, as we see in case of
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those two companies, we can derive a
sustainable growth rate from corporate
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fundamentals. And today I'm going to show
you how to calculate the sustainable
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growth rate and how to apply it for the
dividend discount model. To do that, we
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need to get some more fundamental data
on the companies that we're trying to
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value. For those three
companies, I have got the
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fundamental data from the corporate
reporting on the total common equity at
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the start of the year and at the end of
the year, the net income for common
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shareholders, net income for shareholders
after preferred dividends and minority,
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as well as the total dividends that the
company has paid. How to apply those to
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derive the sustainable growth rate? Well,
that's what I'm going to cover right now
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The logic of the sustainable growth rate is
to determine at what rate the company
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can grow its own assets - its total book
equity - by using just the resources
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available within the company, without
attracting leverage, because obviously
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the firm cannot just leverage itself to
infinity, the company can't attract
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infinite debt, the company can't just
grow indefinitely using loans. So the
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only source of growth that is infinitely
sustainable is reinvestment, when the
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company retains some of the earnings it
makes to expand its operations,
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to reinvest into its own assets, to increase
its capability to generate further
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earnings for investors and so on and so
forth
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So, overall, this estimate of the
sustainable growth rate is equal to the
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return on common equity times the
retention ratio, so the company can grow
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faster if it retains more earnings and
the company can grow faster if it just
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makes more. So to calculate the return on
common equity we need to divide that
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income for common shareholders by the
average total common equity at a
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particular year. To calculate the average
of common equity, we just need to find
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out the average of total common equity
at the start of the year and at the end
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of the year so: "start" by "end" and divided by 2, and we can drag this
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formula around and apply for all 3
companies. And the return on common
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equity is just net income for common
shareholders divided by averaged common equity
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So how many pounds does one pound of
common equity make within a year?
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So for Diageo if the return on common
equity is around 34.5% and we can
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apply it for all 3 companies and we can
see that the return on equity varies
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substantially across companies because
they have different business models,
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different levels of risk and, in general,
different assets yield different types
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of return. And also return on common
equity obviously depends on the leverage
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the company makes, if a lot of assets
owned by the company because of the high
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levels of debt it currently holds, then
the return on equity will be higher
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So those are the factors that might
influence return on common equity. So now,
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we have to calculate the retention ratio.
The retention ratio is the proportion of
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company's earnings that a company leaves
within itself, that the company does not
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distribute among its shareholders as
dividends, that the company has available
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for future reinvestment. So naturally, the
retention ratio is equal (1 - the
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dividend payout ratio) and the dividend
payout ratio is very very easy to
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calculate, it's just the total dividends
paid out
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divided by the net income that is
available for shareholders
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after preferred dividends and minority
interest are accounted for. So without
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further ado, dividend payout ratio is
equal to total dividends divided by net
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income after profit and minority. And
payout ratio is also quite variable
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across companies because generally
companies that are in high-growth stage,
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that have a lot of opportunities to
expand, prefer to pay out less so they
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have more funds available to reinvest
into the expansion of the current
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operations.
Well, companies at maturity that don't
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need much funds to grow to sustain their
current operations might prefer to
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distribute a greater proportion of their
earnings as dividends, and we can see
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just that: Intel Corp that is growing at
12% a year - remember - distributes only
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around 26% of its earnings as dividends,
well, Royal Dutch Shell - a well
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established energy company - distributes
more than 60% of its earnings as
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dividend. So, the retention ratio is
equal to just (1 - the dividend payout
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ratio) and we can calculate it for all
our three companies. And now we have
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everything we need to get the
sustainable growth rate, and the
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sustainable growth rate - as already
discussed - is the return on common equity
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times retention ratio. And we can see
that those three companies by using only
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the funds that are available from within
the company, can grow at around 16%
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around 4% and around 21% respectively.
And now we can apply the same logic that
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we did with historical growth rates, we
can just apply the sustainable growth
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rate to figure out the future dividend
that we'll get next year if we buy this
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stock today, and using the assumption
that the dividends will grow at the
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sustainable growth rate indefinitely, we
can figure out the fair value of this
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particular stock. The future dividend is
just equal to the most recent dividend
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times (1 + the sustainable growth rate),
and we can use the formula that we all
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already know, just dividing future
dividend by (the required rate of return -
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- sustainable growth rate) and applying
it for all three companies, we see that
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the sustainable growth rate is very very
high for Diageo and Intel Corp,
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it's much higher than their respective
required rate of return, so we get
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bizarre negative results for those two
companies in case of the sustainable
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growth rate. But it just means that the
sustainable growth rate constant growth
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model is simply inapplicable for those two companies.
In the case of Royal Dutch Shell, though, the
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sustainable growth rate is plausible,
it's possible that this company will
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grow at 4% per year indefinitely, and
using this value for growth rate, we can
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derive the fair price of Royal Dutch Shell
it at 32.70 pounds, reasonably
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greater than its current market
value of 22.44 pounds.
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And sustainable growth rate is more applicable for Royal Dutch Shell than
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the historical growth rate, as we already
acknowledged in the last video that a
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dividend growth path for Royal Dutch
Shell is unstable, at some years
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dividends grow a lot, at some years they
grow a little and in some years they
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even decrease. So for Royal Dutch Shell,
the sustainable growth rate constant
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growth model is arguably the most
applicable. But what can we do for the
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likes of Intel Corp, whose historical
growth rate is very very high, whose
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sustainable growth rate is just as high or
even higher, and the constant growth
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model is inapplicable? Well, we will talk
about the two-period dividend discount
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model and how to apply it next time.
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