Dividend-Yield-Plus-Growth-Rate or Discounted Cash Flow Approach

Cost of common stock

To estimate cost of equity, let’s consider 3 models:

1) The Capital Asset Pricing Model

2) The discounted cash-flow method

3) The over-own-bond-yield-plus-judgmental-risk-premium approach

CAPM

To estimate the cost of common stock using CAPM we need to proceed the following steps:

1) To estimate the risk-free rate.

We can’t truly find riskless rate upon which to base CAPM, so it’s common to use rate on 10-Year T-bonds as risk-free rate.

2) To estimate the market-free risk premium.

The market risk-free premium is not directly observable, so there are different approaches to estimate the market risk premium.

Historical risk premium

We calculated historical market risk premium, using the data from 1982 to 2011 year of S& M 500 annual market return and 10-year U.S. T-bonds. RPm =5, 86

Forward-Looking Risk Premium = 4, 4%

An alternative to the historical risk premium is ex ante risk premium. In this model we use forward-looking data. According to the model, the market is in equilibrium, so required rate of return = expected rate of return. We obtain the market’s actual dividend yield by using estimation for the S& P 500 reported dividend Yield in October 2012 = 2, 07%

Constant dividend growth rate is calculated the following way:

A. I-rate on 10-year T-bonds=3.2% -1, 69%=1, 53%

B. Expected inflation will be somewhere between 1, 52% and historical average inflation (3%)[1]

C. Reasonable estimate of sustainable population growth is from 1% to 2, 5% [2]

D. Combine long-term population growth with expected inflation suggests that long-term constant growth rate is around 2, 52% to 5, 5%

E. Mid point is reasonable estimate of g=4, 01%

Expected market risk is =2, 07%+4, 01%= 6, 08%

Forward-looking market risk premium= RPm2 =6, 08%-1, 68% =4, 4%

Survey of Experts

According to the recent surveys of professionals[3] “Market Risk Premium Used in 82 Countries in 2012: A Survey with 7, 192 Answers”, the average market risk premiums in U.S. in 2012 from a broad survey of professors, analysts and companies equals to 5, 5% (RPm3).

We believe that the estimate of market risk premium by survey experts is the most appropriate as it takes into consideration many factors.

3) The next step of our CAMP model is to estimate beta. The beta is estimated to be 1, 17 (Part№3)

Thus, according to CAPM model, and using different approaches to the estimation of market risk premium, cost of equity is:

Rs1= 1, 68%+ 5, 86%*1, 17= 8.54%

Rs2= 1, 68%+ 4, 4%*1, 17= 6, 83%

Rs3= 1, 68%+ 5, 5%*1, 17= 8, 12%

Outcome: for the further use of the cost of common stock, using CAPM model it’s rational to use Rs3, because it includes RPm, estimated by the specialists. Historical risk premium is not enough appropriate for the estimation of the current risk premium. As stocks returns are quite volatile, it leads to the low confidence in the estimated averages. Moreover historical average is extremely sensitive to the period over which it is calculated. And our estimation of market risk premium for g2 can’t be seen as reliable, as it relies 2 unrealistic assumptions that our Company will not repurchase any stocks and the growth in the dividend will be constant (actually it’s not constant for Disney).

Dividend-Yield-Plus-Growth-Rate or Discounted Cash Flow Approach

The second approach to estimate the cost of equity bases on the assumption that the markets are at equilibrium and required rate of return equals to expected return.

Let’s estimate inputs for the DCF model.

Price of the stock=dividend expected to be paid at the end of the year 2012 divided by required rate of return minus expected growth rate in dividends.

1) Current stock price (20.11.2012)=48, 67$

2) Dividend growth rate estimation

Historical dividend growth rate [4]

The data of history of dividend payments is available on the web-side dividata.com. As we can note, dividends were relatively stable in the past, and there are reasons to believe that this trends will continue. According to the Dividata.com, which offers dividend analysis and detailed dividend history, Disney Company has quite good latest estimation of analysts about[5]:

- Overall Rating: Average

The overall rating is a weighted average of the three other rated categories listed below. It is a general indication of the health of a dividend.

- Dividend Yield: Fair

This indicator measures a stock's current dividend yield, and compares it to similar stocks and historical yields.

- Dividend History: Excellent

The rating for dividend history is determined by looking back at the frequency and amount of historical dividend payments.

- Dividend Increases: Above Average

This indicator measures a stock's history of dividend increases; consistent increases over time will produce a favorable rating.

Let’s use the divided amounts from the last 10 years to calculate historical average growth in dividends:

The historical growth rate equals to 11, 88% (g1). However we may note that dividends from the last year (2011) are significantly larger than that of 2010. The reason for that can be growing retained earnings[6].

Disney is a mature company, its earnings and dividend growth have been relatively stable in the past, and investors can expect these trends to continue, so, probably, the past estimates can be used as an estimate of the expected future growth rate.

Retention growth model

First of all, to use this method we need information from Yahho about Dividends & Splits

So having this information the percent of net income that the firm pays out as dividends in our case equals to 19.00%, that means Disney pays out 19, 00% of net income as dividends. This is not a big amount, as if we consider payout ratio of S& P500 companies[7], we can see that the majority of them has payout ratio higher.

For the next step we need information about return on equity (ROE), which shows how the profit margin, the total assets turnover, and the use of debt interact to determine the return on equity.

We use Yahho data: ROE=15, 17%

Our return on equity equals to 15.17%. Now we can calculate dividend growth rate using our model: g2=ROE*(1-Payout ratio), g2= 16.12%

Analysts forecasts [8]

According to Value Line analysis dividends annual growth rate over the next 5 years equals 16%.

Thus g3=16%. So eventually, we have all data to calculate price of the stock.

The results are the following:

From our point of view, g3 is the best choice for further calculations, it’s almost the same as g3.

There is no significant difference in g2 and g3. However studies have shown that analysts’ forecasts usually represent the best source of growth rate data for DCF cost of capital model[9]. Moreover analysts, probably, take into account more factors than other models, which are mostly based on mathematics, but not on the logic itself.