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The Coca-Cola Company Message Board

  • Novalis_97 Novalis_97 Aug 20, 1998 3:40 AM Flag

    Beethoven_57: dividend discount model

    Here is what I think you are looking for, an
    explanation of why in the dividend discount model, g cannot
    exceed r. The excerpt is from the finance textbook,
    "Essentials of Investments," by Bodie, Kane, and Marcus;
    McGraw-Hill; 1998; page 360:

    "The constant growth DDM
    (i.e., PV = C / (r - g)) is valid only when g is less
    than r. If dividends were expected to grow forever at
    a rate faster than r, the value of the stock would
    be infinite. If an analyst derives an estimate of g
    that is greater than r, that growth rate must be
    unsustainable in the long run. The appropriate valuation model
    to use in this case is a two-stage DDM."

    So
    you see, g may be greater than r in the short-run --
    but not in the long run. As I mentionned before,
    Buffett plugs in "owner earnings" instead of dividends as
    "C" in PV = C / (r - g). Incidentally, you'll find a
    similar paragraph like the above in every finance
    textbook you open (look up "dividend discount model" in
    the index).

    To reiterate, your point about not
    being able to use the perpetuity formula when g is
    greater than r is well-taken, however the case never
    arises that a company's g will be greater than the
    discount rate, r, in the long run. A company's g may be
    greater than r temporarily but eventually it will fall
    below r. The reason is because of a company's life
    cycle, wherein a company will experience a growth or
    "exponential" stage, followed by a slower "maturity" phase. For
    such companies, a "two-stage" dividend discount model
    is appropriate, the first stage corresponding to the
    company's exponential phase, wherin g > r, and the
    second stage corresponding to its maturity phase,
    wherein g < r. Buffett himself often talks about
    Berkshire not being able to grow at 24% forever. He cites
    Carl Sagan's example of bacteria: though they could
    double in mass every 20 minutes forever into the future,
    they don't because the world (and bacterial substrate)
    is finite. Likewise, any company's positive-NPV
    projects are finite. Coke will reach its "maturity" phase
    when every man, woman, and child on Earth drinks 10
    Cokes a day (like I do).

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