unlikedividends,arenotsmoothedout.Inotherwords,afirm
maybuyback$3billioninstockinoneyearandnotbuyback
stockforthenextthreeyears.Consequently,a muchbetter
estimate of the modified payout ratio can be obtained by
lookingattheaveragevalueoverafour-orfive-yearperiod.
Inaddition,firmsmaysometimesbuybackstockasawayof
increasingfinancialleverage.Ifthisisaconcern,wecould
adjust for this by netting out new debt issued from the
calculation:
Adjusting the payout ratio to include stock buybacks will
haverippleeffectsontheestimatedgrowthandtheterminal
value.Inparticular,themodifiedgrowthrateinearningsper
share can be written as:
Eventhereturnonequitycanbeaffectedbystockbuybacks.
Sincethebookvalueofequityisreducedbythemarketvalue
ofequityboughtback,afirmthatbuysbackstockcanreduce
its book equity (and increase its return on equity)
dramatically.Ifweusethisreturnonequityasameasureof
themarginalreturnonequity(onnewinvestments),wewill
overstatethevalueofafirm.Addingbackstockbuybacksin
recentyearstothebookequityandreestimatingthereturnon
equitycansometimesyieldamorereasonableestimateofthe
return on equity on investments.
ILLUSTRATION 5.5: Valuing with Modified Dividend
Discount Model: ExxonMobil