Spread-Driven Dividend Discount Models
Posted: 9 May 2001
A key determinant of shareholder value is the franchise spread - the company's incremental return on new investments over the cost of capital. Explicitly incorporating this spread into the valuation process paves the way for a more compact, two-parameter formulation of the standard three-parameter dividend discount model. This transformation leads to a number of interesting implications. In particular, the spread-driven representation of the DDM (1) clarifies the role of growth-driven ROEs versus the role of spread-driven ROEs, (2) facilitates the development of two-phase models that reflect a typical company's earnings pattern, (3) shows how earnings growth and franchise spreads can underpin a wide range of P/E levels, (4) addresses the problem of artificially high P/Es being forced by low estimates for the risk premium and/or the inflation rate, (5) provides a useful expression for the growth rate of shareholder value, and (6) under certain stability conditions, leads to a pro forma equity duration that is - surprisingly - equal to the P/E itself.
JEL Classification: M41, G12
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