Check cash flow of a firm before buying its stocks

Published: February 23, 2018 3:40:03 AM

Money has time value and a rupee received today is more valuable than a rupee to be received after five years

Constant Growth Model, Gordon Growth Model, GDP growth rate, cash flows, stocksThe first dividend discount model, also termed as the Constant Growth Model or the Gordon Growth Model, because it was developed by a researcher named Gordon, assumed that dividends will grow at a constant rate.

Sunil K Parameswaran

The crux of finance theory is that the value of a security is the present value of the stream of cash flows that it provides. So, in order to obtain a value, it is essential to project the cash flows over the lifetime of the security, and then compute the present values of these cash flows. This is needed since cash flows got at different points in time cannot be simply added up. For, money has time value and a rupee received today is more valuable than a rupee to be received after five years. Thus, it not only matters what you get, it also matters when you get it. If we apply this logic to a stock, we will deduce that its value is the present value of an infinite stream of dividends. The stream is infinite because since the issuer is assumed to be a going concern, the stock has no maturity date. However, no analyst can forecast an infinite stream of cash flows. Consequently it is imperative to make an assumption about how the cash flows from a security will evolve over time.

Dividend discount model

The first dividend discount model, also termed as the Constant Growth Model or the Gordon Growth Model, because it was developed by a researcher named Gordon, assumed that dividends will grow at a constant rate. Each item of the projected stream has to be discounted at the rate of return demanded by the equity investor or the cost of equity. For the discounted stream to converge to a finite value it is essential to assume that the growth rate is lower than the cost of equity. In practice, the growth stream is estimated using past data. The analyst has the option of computing an arithmetic or a geometric average. There are real life limitations to the computed constant growth rate. The projected growth rate cannot exceed the forecasted long-term GDP growth rate for the country in which the business operates. Otherwise the implication would be that the firm would eventually become larger than the economy. For multinational companies, which operate across geographies, a logical limit for the dividend growth rate will be the long-term GDP growth rate for the world as a whole.

Shortcoming of the model

One of the shortcomings of this model is that dividends are assumed to grow at a constant rate from time zero onwards. In real life, a better assumption would be a high growth rate in the initial years followed by a constant growth rate. This lead to the development of the two-stage model: A high growth rate for a certain period, followed by dividends that grow at a constant rate. While the two-stage model is logically more appealing, it assumes that at the end of the initial high growth phase, the growth rate immediately reverts to the assumed constant growth rate.

A more appealing assumption would be a high growth phase followed by a phase in which the growth rate declines linearly to a value, at which it remains constant thereafter. This is known as the three-stage model.In both the two-stage and the three-stage models, we need to make an assumption about how long the initial high growth phase will last. In the three-stage model, we also need to make an assumption about the length of time during which the growth rate will decline linearly and reach the constant growth value.

The author is visiting faculty at various business schools including IIMs

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