Dividend Investing - How to use Discounted Cash Flow Analysis to value Dividend Stocks

Touzibozhu
Dividend Investing Dividend Stocks

What is Discounted Cash Flow Analysis (DCA)?

Discounted Cash Flow Analysis or DCA is one of the best methods to estimate the worth of an investment. In DCA, the value of an investment is determined by the sum of its future cash flows discounted back to present value at an appropriate discount rate or a required rate of return for the investor.

What is the Discounted Cashflow Model (DDM)?

For dividend paying stocks, the type of cash flow used in the analysis is the stock’s regular dividend payments and the Dividend Discount Model (DDM) Cash Flow Analysis is used to determine the Intrinsic Value of the stock.

There are 2 types of future cash flows which determine the Intrinsic Value of a Dividend Stock:

    • Future regular dividend payments over the Holding Period

    • Expected Future Stock Price at the end of the holding period
        • Depending on whether there is capital appreciation in the stock price over the holding period, this cashflow can either add or substract from the Intrinsic Value of the stock.

These two cash flow components, when discounted back to the present value at the appropriate discount rate, determine the Intrinsic Value of the Dividend Stock.

How to estimate the Intrinsic Value of a Dividend Stock using the Dividend Discount Model Cash Flow Analysis?

The following sections explain how to estimate the Intrinsic Value of a Dividend Stock using the Dividend Discount Model. It is a more detailed explanation of the valuation model which I previously used to determine the Intrinsic Values of the Industrial And Commercial Bank of China (ICBC) and the Bank of China (BOC).

1. How to determine the appropriate Discount Rate in the Discounted Cash Flow Analysis of Dividend Stocks?

The appropriate Discount Rate in a Discounted Cash Flow Model is dependent on 3 factors, namely the stock Beta, the Risk-Free Rate and the Market Risk Premium. More details on these factors are provided below:

    • Beta: The Beta of a stock is the measure of its volatility relative to a particular stock index. It is widely used as an indicator of the riskiness of a stock. The beta of a stock can be obtained from many financial websites such as Bloomberg, Yahoo Finance, Financial Times, Wallstreet Journal etc.

    • Risk-free Rate: The Risk-free rate is the theoretical rate of return which is considered to be of zero-risk to the investor. In practice the 10 year government bond is usually used as a proxy for the Risk-free Rate.

    • Market Risk Premium: The Market Risk Premium is the difference between the Risk-free Rate and the Expected Return of the Market Portfolio. Market Risk Premium data can be obtained from Market Risk Premia.

    • Discount Rate: According to Capital Asset Pricing Model or CAPM), the Discount Rate is the Expected Rate of Return required by a rational investor as adequate compensation for an investment in a risky asset.
        • Discount Rate, Ke = Risk-Free Rate + Beta x Market Risk Premium

2. How to forecast the cashflow or dividend payments over the Holding Period?

The following steps explain the method used to forecast dividend payments for the cashflow analysis:

    • Holding Period: 10 years.

    • EPS Growth Rate over Holding Period: gN = A conservative estimate of EPS growth rate over the holding period of the investment.

    • EPSN+1 = EPSN x (1 + gN+1)
        • Estimate the EPS for next year by multiplying the current year EPS with (1 + estimated EPS Growth Rate for next year)

    • Terminal Growth Rate: gn = This is the sustainable growth rate of the EPS into perpetuity at the end of the Holding Period. The terminal growth rate cannot be higher than the sustainable growth rate of the GDP.

    • Dividend Payout Ratio: The Payout Ratio is the proportion of net profit that is paid out as dividends to common stockholders.
        • PORN = (DividendsN) / (Net profitN) x 100%

    • Dividends per share (DPS): Amount of money payable as dividends to shareholders for each ordinary share.
        • DPSN = EPSN x PORN

Dividend Discount Model Cash Flow Analysis Table
Dividend Discount Model Cash Flow Analysis Table

Example of Dividend Discount Model Cash Flow Analysis

3. How to estimate the future stock price at the end of the Holding Period?

    • Retained Earnings per share: REPSN = EPSN - DPSN
        • Retained earnings is the amount of net earnings leftover after dividends are paid out to shareholders.

    • Book Value Per Share: BVPSN+1 = BVPSN + REPSN+1 (assuming no stock buybacks)

    • Return on Equity: ROEN = (Net profitN) / (Average Book ValueN)

    • Expected Stock Price: PN = PBVN x BVPSN
        • Expected Future Stock Price in Year 10: P10 = PBV10 x BVPS10

How to calculate the Intrinsic Value of the Dividend Stock and the Margin of Safety?

The Intrinsic Value of a Dividend Stock is determined by the Present Value of its future dividends and the Present Value of its future stock price at the end of the Holding Period.

    • Present Value of Cash flow: PVCF = Sum of Discounted Dividend payments received over the Holding Period
        • Eg: the Present Value of the Dividends in Year 10 = DPS10 / (1 + Ke)10

    • Present Value of the Future Stock Price: PVSP = P10/(1+Ke)10

    • Intrinsic Value of Stock = PVCF + PVSP

    • Margin of Safety = (Intrinsic Value - Stock Price)/(Intrinsic Value) x 100%

Summary and Conclusion

In conclusion, the Dividend Discount Model Cash Flow Analysis is the preferred method for estimating the Intrinsic Value of a Dividend Stock. It is particularly well suited to mature companies with stable businesses yielding sustainable profits and having a consistent dividend policy.

Disclaimer:

This article is a record of the thinking behind a personal investment decision. It does not represent any recommendation to purchase any stock mentioned in the article. As always, readers are strongly advised to do their own due diligence before making any investment decisions.