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Bridge over ocean
1 November 2000 Financial Analysts Journal Volume 56, Issue 6

Spread-Driven Dividend Discount Models

  1. Martin L. Leibowitz, PhD

A key determinant of shareholder value is the franchise spread—the company's incremental return on new investments over the cost of capital. Explicitly incorporating this spread into the valuation process paves the way for a more compact, two-parameter formulation of the standard three-parameter dividend discount model. This transformation leads to a number of interesting implications. In particular, the spread-driven representation of the DDM (1) clarifies the role of growth-driven ROEs versus the role of spread-driven ROEs, (2) facilitates the development of two-phase models that reflect a typical company's earnings pattern, (3) shows how earnings growth and franchise spreads can underpin a wide range of P/E levels, (4) addresses the problem of artificially high P/Es being forced by low estimates for the risk premium and/or the inflation rate, (5) provides a useful expression for the growth rate of shareholder value, and (6) under certain stability conditions, leads to a pro forma equity duration that is—surprisingly—equal to the P/E itself.

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