Extensions of the Dividend Discount Model

One reason for the fall of the dividend discount model from favor has been the increased used of stock buybacks as a way of returning cash to stockholders. A simple response to this trend is to expand the definition of dividends to include stock buybacks and to value stocks based on this composite number. In this section, we will consider the possibilities and limitations of this expanded dividend discount model and also examine whether the dividend discount model can be used to value entire markets or sectors.

An Expanded Dividend Discount Model

In recent years, firms in the United States have increasingly turned to stock buybacks as a way of returning cash to stockholders. Figure 5.4 presents the cumulative amounts paid out by firms in the form of dividends and stock buybacks from 1989 to 2002.

The trend towards stock buybacks is very strong, especially in the 1990s. By early 2000, more cash was being returned to stockholders in stock buybacks than in conventional dividends.

What are the implications for the dividend discount model? Focusing strictly on dividends paid as the only cash returned to stockholders exposes us to the risk that we might be missing significant cash returned to stockholders in the form of stock buybacks. The simplest way to incorporate stock buybacks into a dividend discount model is to add them on to the dividends and compute a modified payout ratio:

, Dividends + Stock Buybacks

Modified dividend payout ratio =---

Net Income

While this adjustment is straightforward, the resulting ratio for any year can be skewed by the fact that stock buybacks, unlike dividends, are not smoothed out. In other words, a firm may buy back $ 3 billion in stock in one year and not buy back stock for the next 3 years. Consequently, a much better estimate of the modified payout ratio can be obtained by looking at the average value over a four or five year period. In addition, firms may sometimes buy back stock as a way of increasing financial leverage. If this is a concern, we could adjust for this by netting out new debt issued from the calculation above:

, Dividends + Stock Buybacks - Long Term Debt issues

Modified dividend payout =-----

Net Income

Adjusting the payout ratio to include stock buybacks will have ripple effects on the estimated growth and the terminal value. In particular, the modified growth rate in earnings per share can be written as:

Modified growth rate = (1 - Modified payout ratio) * Return on equity Even the return on equity can be affected by stock buybacks. Since the book value of equity is reduced by the market value of equity bought back, a firm that buys backs stock can reduce its book equity (and increase its return on equity) dramatically. If we use this return on equity as a measure of the marginal return on equity (on new investments), we will overstate the value of a firm. Adding back stock buybacks in recent year to the book equity and re-estimating the return on equity can sometimes yield a more reasonable estimate of the return on equity on investments.

Illustration 5.5: Valuing with modified dividend discount model: Exxon Mobil

In November 2005, Exxon Mobil was the largest market cap company in the world. With the surge in cash flows generated by rising oil prices over the previous four years, Exxon had augmented dividends with stock buybacks each year. Table 5.3 summarizes the dividends and buybacks between 2001 and 2004.

Table 5.3: Dividends and Stock Buybacks: Exxon Mobil
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