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Jan 17, 2008

Applying Dividend Discount Model (DDM) to 'State Bank of India' (SBI)

Dividend Discount Model values a firm's equity on the basis of the future dividends that the company is expected to give. Discounting all the future dividends gives the value of the stock as this is the only money an investor is going to get if he keeps the stock till perpetuity.

The general valuation formula for DDM is:
P = D1/(k - g)

where
P - ideal price of the stock
D1 - dividends for the year 1
k - cost of equity/ discounting rate
g - growth rate of the dividends

There are some assumptions in this model which require careful use of this model for finding the intrinsic value of a stock based on its dividends.

We will use a live example of State Bank of India (SBI) to illustrate the use of DDM. The following is the last 10 year dividend history of the company:

Year End Total Dividends paid (Rs crores) PAT (Rs crores) Retained Earnings (Rs crores) Retention ratio, b
Mar-98 211 1861 1650 0.89
Mar-99 211 1029 818 0.8
Mar-00 263 2051 1788 0.87
Mar-01 263 1880 1617 0.86
Mar-02 316 2423 2107 0.87
Mar-03 447 3105 2658 0.86
Mar-04 579 3681 3102 0.84
Mar-05 658 4305 3647 0.85
Mar-06 737 4405 3668 0.83
Mar-07 737 4534 3797 0.84



Using this we find that SBI has policy to retain about 85% of their earnings and distribute 15% as dividends to its shareholders. The retained earnings add on to the shareholder's equity and should earn profits for SBI. For each year we also looked into the returns on the equity (ROE) for SBI. the data is as follows:

Year End Retention ratio, b ROE Growth rate, g
Mar-98 0.89 21.2 18.8
Mar-99 0.8 10.3 8.2
Mar-00 0.87 18.2 15.9
Mar-01 0.86 14.7 12.6
Mar-02 0.87 17 14.7
Mar-03 0.86 19.2 16.4
Mar-04 0.84 19.7 16.6
Mar-05 0.85 19.4 16.5
Mar-06 0.83 17 14.2
Mar-07 0.84 15.4 12.9


We have calculated the growth rate of dividends using:
growth rate = retention ratio X Return on equity ; g = b*ROE
Since dividends next year will be equal to this year's dividends plus the earnings on the retained earnings of this year with SBI.

The average growth rate for the 10 year period was about 14.7%.

SBI paid dividends of Rs 14 per share in 2007. Hence D0 = 14.
D1= 14*(1+g) = 14 * 1.147 ~ 16

Finding the discount rate is the trickiest part of the valuation and it depends on many factors and can be estimated using CAPM or other similar models. For simplifications we will take cost of equity as given in this case. We will take cost of equity as 15% and assume that SBI will enjoy this high growth for next 20 years before settling at something less than India's GDP growth rate (~ 7 %) and find out the value in the next article. Till then you can try it on your own.

[Hint: SBI is currently trading at 2400]


[To be completed in next post...]

1 comment:

Anonymous said...

What's the rationale for the growth rate formula? In other words, how is g related to ROE and retention ratio?

Aside from the foregoing, your methodology is easy to follow. Thanks

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