Estimating Dividend Growth

I often get students/groups who, when it is time to do the stock price evaluation on the term project, say “we don’t even know where to start.” Below is what I’vesaid in class about five times -- it is where you start.

In several of these items, you use historical data for the company. The principle is that you are going to base expectations of the future partially on what the company has done in the past. I am not saying that past performance equals your expectation of the future, this is not mechanical thinking. What I am saying is that past company performance along with other information about your company, its industry, and information from experts can,taken all together, inform your expectations. Without looking at any hard data, you are perhaps just pulling numbers out of the air. So, start with some calculations using the company’s financial data.

First calculation:You are projecting dividends, which are paid out of net income, so you start thinking about dividend growth by examining EPS growth. EPS growth is fundamental driver ofdividend growth. Get EPS for at least the last 5 years and calculate the %change and take an average, maybe throw out the high and low (Olympic average). This is a starting point. Sometimes this calculation has issues and sometimes it gives you the wrong idea. For example, you can’t calculate the percentage change from a year with zero or negative EPS to a year with positive EPS, and thisshould leave you uncomfortable with the average excluding that year or years. Also, sometimes you conclude that the years included (recent 5 years) just aren’t representative of what you expect in the future.

Second calculation:You look also at ROE multiplied by the retention rate. Get data from the last 5 years on ROE and retention rate. Calculate the average or Olympic average ROE times the average retention rate, or look at it as estimating an ROE level that looks sustainable (and then multiply by a representative retention rate). This gives you another number to consider along with the average growth rate in EPS, as an estimate of the growth rate you are seeking. ROE multiplied by retention rate is the fundamental driver of EPS growth (illustrated with a spreadsheet in lecture). In the data sources we use,it is usually hard to find accurate retained earnings for the year to get the retention rate, so you have to take [1 – (DPS/EPS)] to get the retention rate. Do not include years with negative EPS in the retention rate average. You probably should include years with DPS greater than EPS.

Third calculation:EPS growth faster than sales growth is not sustainable. So, calculate %change in sales for the last 5 years and take the average or Olympic average. Expected future sales growth is an upper bound on EPS growth (which drives dividend growth) so this calculation can cause you to reduce the growth rate.

Consider the industry the company is in (old slow growing industry, new fast growing, etc.) and your company's position (high market share, low market share, etc.), and other factors you know about the industry and company that would affect its growth.[1] It is hard for me to anticipate specifics here, but clearly your company’s future prospects are not unrelated to its industry.

Search for and consider what experts are forecasting for your company’s growth.

Taking all the above information together, use judgment and make a forecast of what you think a reasonable estimate of the company's dividend growth rate would be. Yes, this has a large element of uncertainty and to some students selection of any number seems arbitrary. You are going to use this number to do some calculations and get a value for your company. It is “if this is the company growth rate” then the number I calculate for the present value of dividends is what the company would be worth.

If the growth rate you determine is well less than Ks, use the constant growth model. If it is within a percentage point or two less than Ks or greater than Ks, you have to use a two stage growth model. Estimate how long you think the high growth will last. Then, compute a terminal price and take the present value of these cash flows. This use of the two stage model in the term project is explained in another document on the term project page. You may also wish to talk to me for further explanation. If your company does not pay a dividend, do all the above and thensee me for details of how to proceed.

[1] An industry analysis using Porter’s 5 forces is beyond the expectation in this course, but if you have no idea what to consider for industry analysis, the 5 forces framework is very useful: