# Determining Cost of Equity

This may be a question best asked in another section of the forum, but I figured GD was a melting pot of talent so here goes… What is the best way to determine the cost of equity in a DDM for an extremely fast growing company that should gradually decelerate over time? I want to rule out CAPM from the start for various reasons. Logically, one would use (D1/P0) + g to derive a required rate of return that matches the growth rate that the company is expected to achieve. For instance, if a company has a dividend yield of 5% and an expected dividend growth rate of 20%, the required rate of return to discount that year’s expected cash flow would be 25%. That’s not the problem, however. The problem is when I’m winding down the terminal growth rate to 2%. So for instance, if that company still has a dividend yield of 5% with a 2% growth rate, this implies only a 7% required rate of return. Due to the fact that this is an extremely low discount rate (both on an asbolute and relative basis), my terminal value is going to make up 65% of the fair value price I calculate As of now, I’m thinking that the best way to attack this low required rate of return for Year 10 and beyond cash flows is to increase the assumed dividend yield. For instance…a company that is paying out a 5% dividend yield with a 20% growth rate will not likely not continue to pay only that 5% yield when it is only growing 2% ten years from now. My question, then, is how to project this future dividend yield going forward? One suggestion may be to leave the current price flat heading forward to allow the yield to increase. Doing this, however, gives me an extremely high cost of equity. For instance, a company with a current growth rate of 21% that is decreased over a ten-year period to 1%, and with a current yield of 5.6% that increases to 11% (by leaving the current share price flat) at Year 10 results in an average cost of equity of 15.2%, which seems way too high. Am I going about this calculation correctly? Is there anything I can do to get a more reasonable cost of equity? Is this microcosm to the larger problem of not being able to use a DDM for an extremely fast growing company? Thanks in advance; any help is greatly appreciated

> gradually decelerate If you’re smoothly varying the firm’s characteristics, then ignore any perpetuity-like formulae and simply model each year’s flows and discount directly. Then starting in year 6 your growth, dividend yield, etc. assumptions should match the firm’s competitors, so you can use a perpetuity formula to calculate a terminal value. Why year 6? Because, based on an empirical study I can’t immediately dredge up, outperformance lasts > 5 years only extremely rarely. So your firm will look like competitors no later than 5y out. 15% cost of equity is hardly too high btw.

Darien, Thanks for the insight; I had a feeling you would be the first to chime in. A couple more questions/points for you, though… First off, I project forward cash flows over the next four years (pulled straight from my model). I personally have a problem with attempting to model cash flows achieveable 5 years and beyond from now, as so many things can happen along the way that it doesn’t even seem worth it to me. Once the 5th year hit, I wind-down the dividend growth rate to 2% (in-line with the historical growth rate of the type of companies I’m looking at). Do you think my opinion regarding this has merit? Second, I believe that I have things right for the most part, the exception being the assumption I held of holding the stock price constant to achieve a higher dividend yield at Year 10 and beyond. I think your suggestion of using the industry average dividend yield at that time is very good. Third, if you could ever find that study I would very much appreciate it. Thanks again

I can’t find the exact graph I’m thinking of (which shows the precipitous decline in firms with abnormal growth, as a function of time, from where I pulled the “5y” horizon). If you plug the following paper into Google Scholar you might find some related hits (e…g, Fama,French in 2002, but also look forward in time). I also wouldn’t be surprised if Damodaran took a position on this topic. From http://bear.cba.ufl.edu/karceski/research%20papers/jf%20final%20version%20growth0301.pdf: We analyze historical long-term growth rates across a broad cross section of stocks using several indicators of operating performance.We test for persistence and predictability in growth.While some firms have grown at high rates historically, they are relatively rare instances. There is no persistence in long-term earnings growth beyond chance, and there is low predictability even with a wide variety of predictor variables. Specifically, IBES growth forecasts are overly optimistic and add little predictive power.Valuation ratios also have limited ability to predict future growth.

mlpguy22 Wrote: ------------------------------------------------------- > Once the > 5th year hit, I wind-down the dividend growth rate > to 2% (in-line with the historical growth rate of > the type of companies I’m looking at). Do you > think my opinion regarding this has merit? Damodaran recommends using the 10y bond rate as a ceiling on terminal growth rate. (Note that since this includes inflation, your 2% figure implies contraction.) (I’m assuming your div’s grow at the same rate as the rest of the firm.) > I believe that I have things right for the > most part, the exception being the assumption I > held of holding the stock price constant to > achieve a higher dividend yield at Year 10 and > beyond. Not sure I quite follow – but your stock price should grow at your steady-state growth rate for the firm.

DarienHacker Wrote: ------------------------------------------------------- > mlpguy22 Wrote: > -------------------------------------------------- > ----- > > Once the > > 5th year hit, I wind-down the dividend growth > rate > > to 2% (in-line with the historical growth rate > of > > the type of companies I’m looking at). Do you > > think my opinion regarding this has merit? > > Damodaran recommends using the 10y bond rate as a > ceiling on terminal growth rate. (Note that since > this includes inflation, your 2% figure implies > contraction.) (I’m assuming your div’s grow at > the same rate as the rest of the firm.) > > > I believe that I have things right for the > > most part, the exception being the assumption I > > held of holding the stock price constant to > > achieve a higher dividend yield at Year 10 and > > beyond. > > Not sure I quite follow – but your stock price > should grow at your steady-state growth rate for > the firm. This is what I’m getting at. If I grow my stock price at the same rate that my dividend grows, won’t my dividend yield always remain the same?

Should do.

We did a similar study a few months ago. Like you suggested, we increased our assumed yield in the outer years and based it on a correlation between current yields of other companies and their respective estimated dividend growth rates. In other words, to find our assumed yield, we took our assumed 2-3% dividend growth rate in the outer years and correlated it to the average yield of other companies that are currently growing 2-3%.