In practice, the use of the dividend discount model is refined from the method we presented in the textbook. Many analysts will estimate the dividend for the next 5 years and then estimate a perpetual growth rate at some point in the future, typically 10 years. Rather than have the dividend growth fall dramatically from the fast growth period to the perpetual growth period, linear interpolation is applied. That is, the dividend growth is projected to fall by an equal amount each year. For example, if the fast growth period is 15 percent for the next 5 years and the dividends are expected to fall to a 5 percent perpetual growth rate 5 years later, the dividend growth rate would decline by 2 percent each year. 5-year dividend growth rate: 9.5% Perpetual growth rate: 4.0% Required return: 11.0% a. Assume that the perpetual growth rate begins 10 years from now and use linear interpolation between the high growth rate and perpetual growth rate. b. How sensitive is the current stock price to changes in the perpetual growth rate? Graph the current stock price against the perpetual growth rate in 10 years to Instead of applying the constant dividend growth model to find the stock price in the future, analysts will often combine the dividend discount method with Payout ratio: Forward PE ratio at constant growth rate: 25% 15 c. Use the forward PE ratio to calculate the stock price when the company reaches a perpetual growth rate in dividends. Now, find the value of the stock today by d. How sensitive is the current stock price to changes in the PE ratio when the stock reaches the perpetual growth rate? Graph the current stock price against the Solution a. The dividend growth rates, dividends, and stock prices are: 1 2 3 4 5 6 7 8 9 10 11 Year Dividend growth: Dividend: In practice, the use of the dividend discount model is refined from the method we presented in the textbook. Many analysts will estimate the dividend for the next 5 years and then estimate a perpetual growth rate at some point in the future, typically 10 years. Rather than have the dividend growth fall dramatically from the fast growth period to the perpetual growth period, linear interpolation is applied. That is, the dividend growth is projected to fall by an equal amount each year. For example, if the fast growth period is 15 percent for the next 5 years and the dividends are expected to fall to a 5 percent perpetual growth rate 5 years later, the dividend growth rate would decline by 2 percent each year. 5-year dividend growth rate: 9.5% Perpetual growth rate: 4.0% Required return: 11.0% a. Assume that the perpetual growth rate begins 10 years from now and use linear interpolation between the high growth rate and perpetual growth rate. b. How sensitive is the current stock price to changes in the perpetual growth rate? Graph the current stock price against the perpetual growth rate in 10 years to Instead of applying the constant dividend growth model to find the stock price in the future, analysts will often combine the dividend discount method with Payout ratio: Forward PE ratio at constant growth rate: 25% 15 c. Use the forward PE ratio to calculate the stock price when the company reaches a perpetual growth rate in dividends. Now, find the value of the stock today by d. How sensitive is the current stock price to changes in the PE ratio when the stock reaches the perpetual growth rate? Graph the current stock price against the Solution a. The dividend growth rates, dividends, and stock prices are: 1 2 3 4 5 6 7 8 9 10 11 Year Dividend growth: Dividend
