Valuing non-dividend paying growth stocks with dividend discount model (Google example)

Even a prudent investor can occasionally became infatuated with a non-dividend paying company. For example, internet seems to be growing and Google is the dominant internet company. Surely Google is a solid investment that is poised to yield double digit returns!

Although Google does not pay dividends, we can still use the dividend discount model (DDM) to estimate the fair net present value (NPV) for Google by making an educated guess on the future dividends and applying some margin of error.

Microsoft can be used as a starting point for estimating the dividends of a tech company: In 80s, Microsoft was growing quickly but was not rewarding investors by paying dividends. Only later, as the earnings growth stalled, has Microsoft started paying dividends. The first payments have been modest but the dividend and the payout ratio has since grown.

If Google follows the similar path, it might introduce modest dividend sometime around 10 years from today. This dividend will be modest at first but can grow quickly for another 10 years. Beyond this, we assume that the market is mature and dividend will grow at a modest rate of 3%.

The spreadsheet below calculates the NPV for Google based on the following assumptions:

1. The earnings growth rate for the next ten years is g1 = 20%.

2. Initial payout ratio after ten years is 10%.

3. The dividend growth rate for the following ten years is g2=25%.

4. The terminal growth rate is g3=3%.

5. The discount rate is r=10%.

Based on the DDM-H analysis, the future value for Google ten years from today is $846.50. Discounted to today, the value for Google is NPV=$323.36 which way less than the current stock price of around $600. Certainly Google is no bargain!

Dividend discount analysis of Google


A link to editable spreadsheet is: https://docs.google.com/spreadsheet/ccc?key=0AlyBMfBlh5aodFdFd1hRQ25GV0tiRjdiU0wtQnJld0E
Feel free to play with the assumptions!

What would justify the current high stock price? Either the investors are happy at a lower discount rate or they are even more optimistic on Google’s growth prospects. For example, reducing the discount rate to r = 8% results in NPV=$545.60. This is closer to market valuation but raises an interesting question: Why would anyone be satisfied with a 8% return on speculative/risky investment that may start to pay off decades from today when the same return can be more safely obtained by investing in for example telecommunication companies? It appears that the market may not properly discounting the risk in growth stocks…


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