In this lesson, we’ll go through the most important part of a dividend discount model – the circular calculation required to estimate dividends issued based on a minimum Tier 1 Common ratio.
You’ll also learn several methods you can use to calculate the terminal value and how to tie everything together to calculate the net present value of equity for JP Morgan.
Dividend Discount Model – Calculating Dividends Issued and Net Present Value Transcript
In this lesson we’re going to finish up our dividend discount model, or at least complete the next step by calculating the common dividends issued, the present value of those dividends and then going over to the right side of the page and calculating the terminal value for JP Morgan here.
So first things first, remember that when we issue common dividends, regardless of whether it’s an operating model for a bank, or a dividend discount, or residual income model we have to do it so that it’s Tier 1 or Tier 1 common ratio stays above a certain level.
In this model we’ve assumed that that ratio is 9.0%, so it has to be at least 9.0%. To make sure that we’re staying in line, let’s first fill in the Tier 1 common ratio right here, so we’ll take the Tier 1 common capital, and divide by the average risk-weighted assets. Take that across.
We see here of course, it’s going up to around 13%, so we’re well in the range and that’s because we have not yet figured in the dividends right here. So to go in and make this dividend’s calculation now, let’s think about what has to happen here.
We know that our minimum ratio is 9.0% and we know that it’s based off of the average risk-weighted assets. So that tells us that the average risk-weighted assets, times the 9.0% here, this is telling us we need to maintain a minimum of $116 billion of Tier 1 common capital at all times.
So just looking at our calculation right here ending common equity, minus goodwill and other disallowed intangibles, and other adjustments we get to $123 billion. So this tells us that the dividends in the first year, just based on these numbers here, are going to have to be in around the $6.0 to $7.0 billion range.
Because we can go down to $116 billion worth of Tier 1 capital, but currently we have $123 billion, so we’re above our requirement, and that tells us intuitively about how much to expect in the first year here.
Now once again, if you have not yet enabled iterative calculations you should definitely do so. Go to ‘ALT + T + O’ for options. In Excel 2003 you can go to the calculations tab. In 2007+ I’m going to go to formulas here, and then make sure that workbook calculations are set to ‘automatic except for data tables’, and that iterative calculations here are ‘checked’, max iterations is 100 and maximum change is 0.001.
So this will be a circular calculation, as the net income calculation already is. So let’s think about what has to happen here again, so we just calculated the minimum Tier 1 common capital with risk-weighted assets times the minimum Tier 1 common ratio, so that’s going to part of this calculation.
What we want to say here is that the common dividends are equal to the ending common equity over here, from the first year from 2009, the historical year in this case. So we’re going to take that number, then we’re going to take the net income, because that’s going to boost our common equity.
Then we’re going to add in the stock issuances down here, because that’s also going to boost our common equity, and then add in stock-based comp, because that’s also going to boost our common equity, add in the exchange rate effect, and then subtract stock repurchases.
This is already a negative, so effectively we’re already subtracting it here. So we have all of this in place, and this has now taken us to, basically, the ending common equity number before we’ve figured in dividends.
Then the next thing we want to do is think about how we get to the Tier 1 capital calculation. We basically have our ending equity right here, which we are now calculating with this formula that I just entered, so we’re calculating the preliminary 2010 ending common equity with this formula.
And then the next thing I want to do here is add in the disallowed intangibles, actually subtract the goodwill and other non-MSR intangibles that are not part of Tier 1 common capital, and also add in the other adjustments right here.
And so this now gets us to our Tier 1 common capital for 2010, before we have taken into account the effects of dividends, so this is telling us what has happened before we’ve issued dividends here.
The next step is to go in, and actually make the final calculation here, that’s going to give us our dividends number. So in this case what we’re going to say is that again, our minimum Tier 1 common ratio here, is defined as the average risk-weighted assets over here, times our minimum Tier 1 ratio, so we’re going to subtract that number.
So we’re subtracting the minimum amount of capital here that we need to maintain on our balance sheets, the minimum Tier 1 common capital. To do that, I’m going to take the risk-weighted assets, and I’m going to multiply by the minimum ratio over here, and I’m going to anchor that with ‘F4’ to make sure it doesn’t shift around.
And so that gives us our common dividends number of $7.0 billion right here. We see that the tier one common ratio as expected stays at 9.0%, because we’ve set our formulas to stay like that. And we see that our ending Tier 1 capital is exactly the minimum of 9.0% here.
So we’re essentially setting up our dividend discount model for JP Morgan, such that the dividends are really a plug in this model, and we’re really looking at what the common equity would be without dividends, and then subtracting the minimum Tier 1 common capital, and then the difference is what goes into dividends right here.
And this by the way, is why many of the models that you see online for dividend discount models, many of the example spreadsheets are actually wrong for banks, because for banks you need to take into account the regulatory requirements, the Tier 1 common capital requirements, the Tier 1 and total capital requirements and so on.
And if you’re not taking these into account, if you’re not taking into account regulatory capital, your dividend discount model is going to be all wrong, because remember for a bank you can’t just assume infinite growth.
It has to be tied to how much Tier 1 total capital and Tier 1 common capital you have on hand. Now this is not quite complete yet, because our dividends here have no limitations. They could be below zero right now, and obviously you cannot have negative dividends, or potentially they could be too high.
They might even be higher than our net income here. To give you an example of that, let’s say that I take the stock issuances here up to $50 billion, hypothetically, well now we have common dividends that are way above our normalized net income.
Technically that can happen, but honestly it’s not going to happen really for a bank. That’s the whole point of looking at dividend payout ratios, dividends over net income or dividends per share over earnings per share.
So we have to put some checks in place to make sure that scenarios like this do not happen. As another example of the problems with this formula right now, let’s say I made the normalized net income $1.0 billion right here. Now our dividends fall to ($8.9) billion, which we know obviously cannot happen.
So we need to add a few checks. First off I’m going to say that our formula is actually equal to the minimum of the net income or this calculation. So this basically puts an upward bound on it and says that the common dividends here can never exceed the net income.
So if we have a situation where that’s the case, we’re just going to use the net income and assume a 100% payout ratio instead. So this is better now, because now if I go back and change the stock issuances to $50 billion, let’s say. Well, now our dividends are bound to our net income.
Now in real life you’re never going to have a 100% payout ratio, but this is at least better than our old approach, which was to let it go to whatever we wanted. Then the other thing we want to do is to handle the other case that I just showed you.
Where if we enter let’s say $1.0 billion for net income here, then our dividends could potentially go negative, so to fix that problem what I’m going to do is use a maximum function, around this entire formula, and I’m going to say that the MAX of 0 or this formula.
So basically what we’re saying here is if this goes below zero then that means we do not have enough net income available, to actually really issue dividends, so we’re just going to assume a payout of zero and zero common dividends instead.
So let’s change net income now to $1.0 billion and now we see that we have no common dividends being issued here. So this now makes our formula robust enough to use throughout the rest of this model.
So with this formula for common dividends in place, I’m going to copy it all the way across using the ‘CTRL + R’ shortcut, and we have it in place right here. We see that now we’re maintaining our Tier 1 common ratio of 9.0% all the way across.
Another thing I want to add in is the payout ratio for the dividends here, so just take the dividends and divide by the net income to common. Copy this across, and so we have that in place and set up.
So the next step here is to go through the process of discounting these dividends to the present value, and then calculating the terminal value for JP Morgan. So to discount the dividends here it’s going to be just like discounting the cash flows, in a DCF for a normal company, except we’re using dividends, and we’re using cost of equity rather than WAC.
Of course the reason we’re using cost of equity here, again, is because the dividends only go to the common equity shareholders of the company. They are not going to preferred holders or debt investors in JP Morgan. So first let’s set up the discount periods. So we’re going to use the mid-year convention here.
The basic idea is that the cash flow or the dividends in this case, come to the company, come to the equity investors throughout the course of the year. They’re not all arriving at the end of the year, so we want to discount by 1.5, 2.5, 3.5, and so on rather than 2.0, 3.0, or 4.0 to reflect this fact, and that’s why we use this mid-year convention here.
So for the discount period, I’m going to take the 0.0 here and add one to it for the first year, copy this formula across. And then for the mid-year discount, I am going to link up to where we’ve actually defined this, and then anchor this with ‘F4’. And then I’m going to add one to this in each year.
So this is basically smoothing out the flow of dividends to the shareholders here, and we’re no longer assuming that the dividends are all coming at the end of the year. Now to actually discount them, we’re going to take our common dividends all the way at the top, and I’m going to divide by one plus the cost of equity. I’ll anchor that, raised to the power of whatever period we’re looking at, so 0.5 for this first year.
Just like a normal company, money today is worth more than money tomorrow, so we’re discounting this by a higher and higher amount over time here. The formula for the present value, again exactly the same mechanically, as what you’d see for the present value of unlevered or levered-free cash flow.
The difference here is we’re using dividends, rather than cash flow and we’re using cost of equity as opposed to WACC. So now I’m going to copy this across. So we get to around $7.0 or $8.0 billion in the final year here for present value.
Now to go over to the side, and calculate the terminal value, so first for the present value of the dividends here, I’m just going to use a simple summation formula, and simply sum up Years 1 through 5 right here, so we have that.
And this is the first part of our calculation for terminal value. Remember that in a dividend discount model, terminal value works very similarly to what you see in a standard DCF. You are summing up the present value of the cash flows or the dividends, then you’re assigning a terminal value.
In this case we’re basing it on price per tangible book value, rather that EBITDA or EBIT or unlevered free cash flow multiples. And of course, you can also use the Gordon Growth method for calculating terminal value here as well.
So for the terminal price to tangible book value here, if we go back and look at the public comps, we see that the median here is 1.3x, 1.1x, then 1.0x, J.P. Morgan is 1.6x, 1.4x, 1.2x, so we could use these numbers as a reference.
Another way to calculate the actual number that we should use here is to actually use a formula to calculate this, based on the return on tangible common equity and the cost of equity, and the earnings growth.
So ideally for the terminal growth rate, we like our net income growth to converge on a specific number, but it looks like that’s not really happening. But what is happening is that our payout ratio for the dividends is or does appear to be converging on around the 62% number right here in 2014.
We see it’s around 64% falling to 62% here in Year 5. So what we’re going to do instead is calculate this based on the dividend payout ratio. So what I’m going to say here is that the terminal earnings growth rate for JP Morgan, is equal to the return on tangible common equity * (1 minus the dividend payout ratio) here.
And so basically the way this works, what we’re saying with this formula is that the return on equity here, part of this return on equity will go to paying out dividends and the other part will be to actually growing our net income here.
So the dividend payout ratio here is about 60%, so we’re saying that 60% of the return on equity is going to paying that out and then the remainder around 40% of the return on tangible common equity here, is going toward actually growing our earnings, outside of the dividends here that are being issued.
So that’s an alternative method that we could use to calculate the terminal earnings growth rate. This works well when the dividend payouts are converging on a specific number, as they are here. It doesn’t work as well if they’re all over the place.
In that case you would just want to pick a number for the normalized net income growth. You can see though, that looking at what we have here, you might actually pick something in this range. It looks like it is decreasing 9.0%, 8.0%, 7.0% and so on, so you’d probably pick something in this range as well.
So with that in place now, one thing that we can do to calculate the price per tangible book value multiplier here is we can look at the return on tangible common equity in the maturity phase, minus the terminal earnings growth rate, and then divide by the cost of equity, minus the terminal earnings growth rate, and this gives us a multiple of around 1.55x.
So this is sort of a formulaic way to calculate the price per tangible book value here, and basically what this formula is saying is that the price per tangible book value should be equal to our return on tangible common equity, minus the earnings growth, divided by the cost to get that return, minus the earnings growth.
So basically here, we’re looking at how much we’re earning, subtracting out how much is going to earnings growth, instead of dividends. And then looking at how much it’s costing us, and again subtracting out how much is going to earnings growth versus the portion that’s going to dividends here.
So that’s an alternative way to calculate it. In this case I’m just going to use 1.50x as our baseline assumption here. And then for the multiples method this is very easy. We’re going to take the 1.50x, and simply multiply by the tangible book value.
In this case, actually the Tier 1 common capital is again the same thing as tangible common equity, the same thing as tangible book value here. So I’m going to take the Year 5 number and simply multiply by that.
Then for the growth method very similar to the Gordon Growth method you see in standard DCF analyses. What I’m going to do here is take our dividends number in Year 5, remember dividends are to a dividend discount model, what unlevered free cash flow or levered free cash flow, are to a standard DCF.
So we’re going to take this, and we’re going to multiply by one, plus the terminal earnings growth rate, which we’ve set to around 5.0% here, and then we’re going to divide by the cost of equity, minus the terminal earnings growth rate.
So again, the idea is similar to what we saw before. We’re assuming that the dividends here are going to grow in perpetuity, by one plus the terminal earnings growth rate. And then we’re going to divide that by how much it’s costing us. So the cost of equity minus how much is going out, not to dividends, but rather to fuel the company’s net income or earnings growth here.
So that gives us a slightly higher terminal value, but clearly these are both about in the same range. And the reason this happens of course, is that they’re related. They’re linked via the price to tangible book value multiple, as we saw before.
So now to get to the present value of the terminal value and the present value of equity, so for present value of terminal value, as with a normal company, the formula here depends on whether we use the multiples method or the Gordon Growth method.
Because for the multiples method we want to be using these standard discount periods, because we’re assuming JP Morgan gets sold at the end of this five-year period.
With the Gordon Growth method we want to assume that cash flows are coming to us evenly throughout the entire year here, so we want to be using the mid-year discount period instead. So for the present value of terminal value, I’m going to first check which method we’re using to calculate terminal value here.
If we’re using the multiples method, then we’re simply going to take our terminal value from the multiples method, and then divide by one, plus the cost of equity, raised to the power of the fifth year here, five.
Otherwise if that’s not the case, if we’re using the growth method instead, I’m going to take the terminal value from the growth method, and then divide by one, plus the cost of equity, raised to the power of our mid-year discount here of 4.5.
And so we get to $144.111 billion for the present value of our terminal value here. To get to the present value of equity, as with a normal company, we sum up the present value of our terminal value, and then the sum of the present value of our dividends in future years.
So in this case, the dividends are only contributing about 25% of the value, of our present value of equity, which is not uncommon. It’s actually fairly standard to see the terminal value taking up over 50% of the value here, in either a DCF or in a dividend discount model, so this is not altogether surprising.
If I were to change this to use the Gordon Growth method instead, we see the present value of equity goes up slightly, primarily because the terminal value here is higher. The sum of the present value of dividends, of course, stays the same.
For now I’m going to set this to keep using the multiples method for this calculation. So that’s how we go through this, figure out how much in dividends JP Morgan is paying out, based on the Tier 1 common capital they have to keep on their balance sheet at all times.
How we discount the dividends to get to the present value and then how we calculate the terminal value for JP Morgan in this dividend discount model. Coming up next we’re going to move into the next step here, which is to move from the present value of equity into the implied share price.
So this is going to be another circular calculation, which we’ll look at. And then we’re going to look at some sensitivity tables to see what kinds of conclusions we can draw about this dividend discount model analysis.
Also in the next video, I’m going to go over a few of the finer points about this analysis, some of the advantages, some the drawbacks, some of the trade-offs when you’re using this type of evaluation versus public comps, precedent transactions, and the residual income model.
Files & Resources
Quick Reference Guides
How to Download These Files:
In Firefox, Chrome, and Internet Explorer:
Right click the link and click Save Link As...
Right click the link and click Download Linked File As...