The Dividend Valuation four essential steps are summarized below. The purpose is to provide a quick reference for this valuation method, illustrate it with an example, and offer a spreadsheet template to facilitate calculations and sensitivity analysis.
We’ve covered how to value a business with a Constant Dividend Growth Rate and, a Multi-Stage Dividend Growth Rate. With this fundamental understanding in place, let’s reduce it to the Dividend Valuation four essential steps.
The key things to remember about using the Dividend Discount Model:
- It values companies paying dividends;
- Usually mature companies with a history of consistent dividends;
- It assumes the company will continue a dividend into the future.
Now, let’s go through the essential steps for calculating intrinsic value using the valuation on Brookfield Infrastructure as an example.
Step One: Calculate the Present Value of the Multi-Stage Dividend Growth
We manually calculated the present value to gain a fundamental understanding of how the formula works. Here we incorporate the formulas into an Excel spreadsheet to speed up the calculations and reduce potential for errors.
The spreadsheet also simplifies calculating sensitivity cases that we’ll discuss shortly. You can download the spreadsheet here:
It is recommended that you take the time to set up a spread sheet to automate calculations for this method. Columns G, H and I show the formulas used in Columns C, D and E for this example.
We start with an estimate of the per share dividend growth for each year. In the Example Table Column C, we assume 7% growth for 10 years. Starting with a $1.74/share dividend in Year 1, Column D shows the growth over time.
Then, we discount each future year’s dividend back to the valuation date (Year 0). We use the 10% opportunity cost as the discount rate in this example. Column E in the Example Table shows the results.
After that, we add them together to determine the total of the discounted dividends during the multi-stage growth phase shown in Cell E16.
Step Two: Calculate the Present Value of the Stable-Growth Dividend Stage
The stable growth rate in this example starts in Year 11 and beyond. We use The Constant Growth Rate Model to calculate the value for this stage of growth, also called the “Terminal Value.” The Terminal Value is the value of dividends from Year 11 ($3.42) and beyond. We are assuming a stable growth rate of 4% (g = 4%) and a discount rate of 10% (r = 10%) in the example below.
Because the Terminal Value is at the end of Year 10, we discount it back 10 years to get the Stable-Growth Dividend Present Value in Year 0:
Step Three: Calculate the Intrinsic Value (IV)
The intrinsic value is the total of the Multi Phase Growth and Stable- Growth Present Values, or $36 per share:
Since the stock price was $35 when we did this analysis and the intrinsic value is $36, the company is expected to return slightly over our required 10% per year.
This is the same result as in the Brookfield Infrastructure post and illustrative of the essential steps for determining intrinsic value using the Dividend Discount Model.
From a practical standpoint using an Excel spreadsheet will save you a lot of time and help reduce errors. It also facilitates sensitivity analysis or alternative cases, where the impact of different assumptions on the outcome can be measured.
Step Four: Sensitivity Analysis
A sensitivity analysis is not a required step to value an investment. However, it is important and, I rarely do valuations without sensitivity cases.
Remember Whitney Tilson’s advice; “Good thinking about valuation is less about plugging numbers into a spreadsheet than weighing many competing factors and determining probabilities. It’s neither art nor science — it’s roughly equal amounts of both.”
The numbers in a spreadsheet provide the “science” or quantitative part. Our assumptions however, are the basis for these numbers and require “good thinking,” for the qualitative “art.”
The sensitivity cases help us better understand the probable range of outcomes. Let’s look at a sensitivity example.
Example of a Sensitivity Analysis
Brookfield Infrastructure has been exceeding their dividend growth range target of 5 – 9%. For example, the recent increase was 11%. If we think this strong growth may continue based on knowledge of the company. Then perhaps our 7% growth above is too conservative.
Recent strong performance and near term significant growth, may indicate to some investors the high end of the dividend growth range may be a better assumption to use, at least for a while.
The case below shows, how changing the dividend growth rate assumption from 7% to 9% for the next five years impacts the intrinsic value.
With a spreadsheet, we can readily change the growth rate to 9% for 5 years, to determine the intrinsic value of $39 per share. With a stock price of $35 at the time of this analysis, as expected the company’s return is more attractive.
Evaluating Investment Information
We all get “stock tip” right? Let’s say you read or hear that this company’s intrinsic value is $100 per share. Then how do you evaluate the quality of this information? One way you can do this is increase the dividend growth rates to find what level of dividend growth would be required for a present value of $100 per share.
A present value of $100 per share requires a dividend growth rate of about 21% per year. That is unlikely to happen and we can conclude that estimate is probably too optimistic.
Sensitivity analysis like this are useful in determining how the assumptions hold up to the “good thinking” test. They also help develop a possible range of outcomes and for testing divergent points of view.
Brookfield Infrastructure’s track record shows a 7% or 9% dividend growth rate is certainly achievable. A 21% is not likely in my view.
The ability to estimate intrinsic value provides the reference point we need to make intelligent investment decisions. The Dividend Valuation Four Essential Steps summarizes a tool we can use with dividend companies. It provides a way to free us from dependency on others on where we place our hard-earned money.
Other discounted cash flow methods methods are available for non-dividend stocks for example. We’ll examine them in the future. Until then let’s put the Dividend Valuation four essential steps to good use to improve our investing. The best of investing to you!
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