Question

Describe the two stage dividend, and two stage cash flow valuations models. Explain for each the steps required to determine the security prices.

Answer 1

Two dividend growth model:

• When dividends grow at a different rate in initial few years and then stabilize over the years, two stage dividend growth model is used.
• Two stage dividend growth model projects dividends separately for every year till the time it becomes stable. Terminal value is calculated using Gordon constant growth model from the year dividend stability is achieved.   Present value of all the dividends and terminal value is calculated and added together to arrive at the value of the stock.

In the first phase, dividends are calculated using stage 1 growth.

Hence, D1 = D0 x (1 + g1); D2 = D1 x (1 + g1); D3 = D2 x (1 + g1) and son on till the horizon period

Please note that g1 is the stage 1 growth.

After the end of horizon period, say end of year n, the dividend is assumed to become stable and mature and hence assumed to grow at a constant growth rate of, let's say g.

Hence, Dn+1 = Dn x (1 + g)

All the future dividends are then discounted using the expected return or cost of equity, say Ke.

Hence, Price today, P0 = PV of all future dividends = D1/(1 + Ke) + D2 / (1 + Ke)² + D3 / (1 + Ke)³ + .....Dn / (1 + Ke)ⁿ + D_HV / (1 + Ke)ⁿ

where D_HV = horizon value of dividends at the end of year n = PV at the end of year n, of all the dividends from year n+1 onward = Dn+1 / (Ke - g)

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Two stage cash flows based valuation model is also very similar to what we have seen in case of dividend above except that:

• Free cash flows are discounted in lieu of dividends. The growth in FCFs have two stages. In the first stage, FCF grows at a rate of g1 and in the second stage cash flows become smooth and mature. Hence, they are assumed to grow at a constant rate.
• In stead of cost of equity, we use WACC as the discount rate.

Hence, Price today, based on cash flows under two stage model will be:

P0 = PV of all future free cash flows = FCF1/(1 + r) + FCF2 / (1 + r)² + FCF3 / (1 + r)³ + .....FCFn / (1 + r)ⁿ + FCF_HV / (1 + r)ⁿ

where FCF_HV = horizon value of free cash flows at the end of year n = PV at the end of year n, of all the free cash flows from year n+1 onward = FCFn+1 / (r - g)