Valuing equity with non-constant growth:
Valuing equity with non-constant growth involves three parts:
1. Determine the stream of cash flows during the non-constant growth period.
2. Calculate the expected dividend in the first year of constant growth. Using this, value equity as if we were at the beginning of the constant growth period.
3. Discount the price of equity in part two and all the dividends during the non-constant back to today.
We must also be aware that often when we move from the non-constant period to the constant period, the firm may change its dividend payout ratio. When this happens we must
Determine the earnings per share in year in the final period of the non constant growth. This can be calculated by dividing the Dividend by the dividend payout ratio.
Multiply this by the new growth rate to get the EPS in the first period of the constant growth stage.
Multiply the new earnings by the new dividend payout ratio.
Example:
It is the beginning of 2009 and you have been told to value a pharmaceutical company called Virotech. Virotech has two stages of growth:
- First stage 2009 – 2012, g = 7% dividend payout 40%
- Second stage, g = 3% and dividend payout is 40%
The current cost of equity (re) = 9.6%
Yesterday the firm announced EPS of 75 cents and paid out 40% of this a dividend of 30 cents per share.
What is the share price?
We will start by drawing a time line of expected cash flows
Do = 0.3
D1 = 0.30 x 1.07 = 0.321
D2 = 0.321 x 1.07 = 0.34347
D3 = 0.34347 x 1.07 = 0.3675129
D4 = 0.3675129 x 1.03 = 0.378538
The next step involves calculating the Price of the share in 3 years time. (i.e. the end of the rapid growth stage – 2012)
We now have the value of the stock in 2012. We must discount this back to the present along with the addition cash flows in 2010 (div1), 2011 (div 2), 2012 (div3)
