# Dividend Pricing Model – Part 2 (Calculation)

I continue our discussion about the Dividend Pricing Model and calculate out the equation!

VIDEO SUMMARY

This video is on calculating out the Dividend Pricing Model. Now when you start actually calculating using this equation, you start to get into the real fun part of Finance. This is where it gets really exciting, when we are using actual numbers and plugging them into the equation.

Let us start by talking about the variables. There are only three variables that you have to understand. There is D, R and G. D is for Dividends, R is for Risk, and G is for Growth. D stands for Dividends and this refers back to the original use of this equation to calculate out a string of dividend payments. You can substitute dividend payments for really any series of cash flows. R stands for risk. Risk is a big driver in this equation. Risk is the amount of uncertainty you have about this string of cash flows. Let us say you have a 15% uncertainty whether you are going to achieve this series of cash flows so you would use .15 for the variable R. G is interesting. G refers to growth. This is how much you expect your cash flow to grow over time. So when we are looking at series of cash flows, it is very common to make an assumption that the cash flow is going to grow. If you are talking about a company, the cash flow of a company is going to grow over time. The population itself grows over time, so hopefully your company is going to grow by some amount. Since your cash flows should also grow, it is important to include that somehow in this equation. The important thing to realize is that G in this equation stands for long-term growth. We are thinking about long term here in the scope of decades. That is important to understand. The way markets look at the valuation of a company is they value the whole long term valuation. A company is going to be around for a long time. So it is going to have a growth rate for the long term. That is what you want to understand. A reasonable assumption would be that over the long term a company would grow at the same rate as the economy. Even if a company is performing really well currently, let us say they are growing at 20% or 30% a year, it is unlikely that they are going to be able to maintain that over the long term. At some point, their competitive advantage is going to peak. Other competitors are going to enter the market, their growth is going to slow down, they are going to reach maturity, they are going to reach market saturation, and so over the long term, growth would be near the growth rate of the economy. So that is the range of growth rates you usually see when people use this equation.

Those are the three variable. What is important to realize is that those three variables are “made up.” They are based on the assumptions you come up with for the future. None of us know what is going to happen in the future. You are coming up with a set of assumptions that you think is going to happen. What this equation does is spit out a price that you would be willing to pay for an opportunity based on what you think is going to happen. It is important to understand that nothing is for certain. Nothing is for sure in the analysis you come up with. Finance is so hard because there is a lot of data involved, and there is a lot of analysis involved to come up with intelligent variables to use for this equation.

Let us start plugging in numbers to the equation. I am going to use an example of a cash flow starting at $10 a period. You are going to get $10 a year stretching out into the future. You expect this $10 to grow at 4% over time, but you have some uncertainty about this. Let us say you use a risk factor of 15%, so you plug in the numbers and get $90.91. I hope you can see how powerful this is. This calculates down to the penny what you would be willing to pay for this opportunity. What is important to realize here is that this is how investment banks work. They rely heavily on this equation. They are valuing companies and stock prices with equations like this to come up with their conclusions. Each investment bank does it a little bit differently. They have their own way of layering on assumptions and it gets much more complicated than this. This is just scratching the surface. There is a lot more complicated equations that get layered on top of this, but at its core, it is this very fundamental equation and everybody uses it. It touches every part of Finance. And it is based on this very simple economic concept: that the price of something is the present value of the future benefits adjusted for risk and growth. When you start understanding this equation, you really start getting a better understanding of prices and opportunities and financial decision making and how investment banks work.

Let us talk through an example to illustrate this. Let us go back to the earlier example of $10 a year valued at $90.91. The next step is you go out and look at the market to see if you actually want to purchase this opportunity. Let us say the market price is $75. What this is telling you is that your assumptions are different from the market assumptions. Everybody else in the market has a different set of assumptions and are buying and selling this opportunity at a significantly different price. You think the opportunity is more valuable than the market. You think it is $90 and the market thinks it is $75. If you purchase this opportunity and you are right, you will make a 21% profit. You will make that profit one of two ways. Either the market will realize your assumptions are right and the market price will correct to your price and then you can sell it and make your profit. Or you could simply hold your opportunity. If your assumptions are right, your assumptions will come true over time and you will eventually get your money that way. So your assumptions are really important. If you can have better assumptions than the market, you can make money. Let us go the other way. Let us say the market price is $100, and you think it is only worth $90. Then you think the opportunity is less valuable than people are paying for it in the market, and you can play markets up or down. The key is understanding where the mispricings are, and what is driving the mispricing.

Let us take this example a step further. Let us look at how the assumptions could be different. Let us bring back the example of the $75 market price. You think the price is at $90. The market thinks the price is at $75. What could be the difference in your assumptions? Well you can look at the equation and you can say that either the cash flow is less than we expect, or the risk is more than we expect, or the growth would be less than we expect. It will be one of those three things. So for instance if you look at growth rates, if you change your assumption of the growth rate to two percent instead of four percent that would bring your price closer to $75. Also you could instead change the risk rate. If you increase the risk from 15% to 18% that also brings your price closer to $75. So I hope you can see how looking at these variables, you start to get a better understanding of your financial alternatives.

We are trying to make some kind of financial decision and these are financial tools that help provide you a process to go through to help make those decisions. If you write out your assumptions, if you plug in your assumptions to these equations, if you calculate out different financial alternatives with quantitative values, you can start getting better understandings of your financial decision, and get a better result. You are going to have better outcomes and that is the goal here. So the Dividend Pricing Model provides you a scientific approach to tackle really difficult business decisions.

To recap we talked about a lot in this video. We started talking about variables in the Dividend Pricing Model. Then we use those variables to calculate out an example. Then we showed how you can use that example to compare it against market prices and discover what that tells you about your assumptions.

Leave a comment down below letting me know what you think! If you find these videos helpful, please subscribe to my YouTube channel.

Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.