Financial Education

Some investors will assume that dividends will grow at one constant rate (for example, the consensus growth rate) during the first stage and then grow at a lower rate (for example, the sustainable growth rate or the average growth rate of the S&P 500) afterward.

Consider Rockwell Automation (ROK). According to Yahoo! Finance it pays a $1.16 annual dividend and is expected to grow 14% annually for the next five years. If an investor with a required return of 10% expects the growth rate in the long-term to be more like the S&P average of 7%, she could use a two-stage model terminating with a Gordon growth model to estimate Rockwell’s value.

The present value of $45.11 is well below Rockwell’s current $70 share price. This could indicate one of several things:

• Rockwell is overvalued
• The 14% growth estimate is too low
• The 7% terminal growth estimate is too low
• The 10% required return is too high
• The terminal dividend estimate is too low
• The market expects the high growth stage to last longer than five years

This particular model would be expected to produce a conservative valuation, as Rockwell’s earnings have grown much faster than 14% for the last five years and are expected to grow 18% next year. These suggest the 14% rate may be too low. Furthermore, the 12% payout ratio would likely increase once the maturity stage is reached, so the terminal dividend estimate is also probably too low. However, by running this simple first past valuation, the investor can pinpoint the areas where her forecast may differ from the consensus view and further analyze those areas.

For more information, see all articles on: Investing in Stocks, Valuation

See also:

Multi-Stage Dividend Discount Models

A Three Stage H-Model Dividend Discount Model

Using the Market Price to Calculate Implicit Return in a Multi-Stage Dividend Discount Model

The Gordon Growth Model

The H-Model Dividend Discount Model