In this article, we’re gonna talk about the total payout model for valuing a firm. Previously we talked about the dividend discount model and how it would value the firm based on a stream of dividends that is going to take place going on into the future and it’ll take the present value of those dividends to come up with a valuation.
However, when we use the dividend discount model we’re not taking into consideration share repurchases and share repurchases are important because for
They reduce the amount of cash that’s available to pay dividends and
They also decrease the share count which is gonna affect earnings per share
and it’s going to affect dividends per share. So the total payout model attempts to address this deficiency of the DDM by accounting for share repurchases.
Just a kind of compare and contrast with the dividend discount model, we’re gonna have our share price is equal to essentially the present value of the future dividends per share. It’s just looking at the firm as a stream of dividends into the future and it’s discounting those dividends back to the present.
In the total payout model, we’re gonna be taking the present value of the future total dividends and share repurchases and then dividing that by the number of shares outstanding to come up with a share price. Let’s get into the specifics when we talk about the present value of future total dividends and repurchases we’re gonna calculate that as follows
We’re gonna have dividends and repurchases and then to discount that to take the present value, we divide it by the cost of equity capital that’s r here and then we subtract the growth rate that’s g. One thing keep in mind is that this is not the growth rate of earnings per share, this is the growth rate of earnings. Then we take all of that once we’ve discounted that then we take that and divide it by the number of shares outstanding.
Let’s jump into an example to make it a little easier for you to understand, let’s say that you want to value this tech firm ABC technologies and so you’ve got the following information about this firm. The shares outstanding are $100,000. We’ve got a growth rate of earnings as 7%, cost of equity capital 11%, and then you’ve got during the year $75000 in dividends and then $50000 share repurchases.
So now to calculate this we’re just gonna apply this model right here. So we have $75000 in dividends and then we’re gonna add in the $50,000 repurchases. Now we’re gonna take this and we’re gonna divide it by that cost of equity capital minus the growth rate of earnings. Cost of equity capitals 11% growth rate of earnings is 7%. We’re just gonna have 0.1 minus 0.07 then we’re going to take this whole thing and divide it by the number of shares outstanding which I’ll just dropdown.
All of this this is gonna give us our share price. Now we just go ahead and we just do the math here do the algebra and I’ll break it down so we’re gonna have one hundred and twenty-five thousand divided by 0.04 that’s just simplifying what’s in this parentheses up here and then we divide that by a hundred thousand and then that’s ultimately gonna have a share price of $31.25. This is our share price of ABC technology valued according to the total payout model.
Now see the difference between the dividend discount model and this total payout model is we’ve factored in this share repurchase. We’re looking at all the distributions to equity holders dividends and share repurchases whereas the dividend discount model was just looking at the stream of dividends and discounting that.