Lesson Objective: To value a firm using the constant growth or multistage dividend discount model (DDM).

In-Depth Notes:

1. The Dividend Discount Model (DDM):
The DDM is a fundamental valuation model that values a stock based on the present value of its expected future dividends. The model is based on the premise that the value of a share of stock is the sum of all future dividends, discounted back to the present at the required rate of return (cost of equity). The DDM is most appropriate for companies that pay regular dividends and have stable dividend policies.

2. The Gordon Growth Model (Constant Growth DDM):
The Gordon Growth Model is a simplified version of the DDM that assumes dividends grow at a constant rate (g) indefinitely.

  • Formula: Value per Share = D1 / (r - g)

    • D1 = Expected dividend per share next year

    • r = Required rate of return (cost of equity)

    • g = Constant growth rate of dividends

  • Assumptions:

    • Dividends grow at a constant rate forever.

    • The growth rate is less than the required rate of return (g < r).

  • Applications: The Gordon Growth Model is suitable for mature, stable companies with predictable dividend growth.

  • Sensitivity Analysis: The model is highly sensitive to the inputs. Small changes in the growth rate or the required rate of return can have a significant impact on the estimated value.

3. Multistage DDM:
The multistage DDM allows for varying growth rates over time, reflecting the life cycle of a company. The model typically has three stages:

  1. High Growth Stage: The company experiences a period of above-average growth.

  2. Transition Stage: The growth rate gradually declines to a sustainable long-term rate.

  3. Mature Stage: The company reaches a stable growth phase, and the Gordon Growth Model is applied.

4. Components of the DDM:

  • Expected Dividends: The expected future dividends are based on the company’s earnings and payout ratio.

  • Required Rate of Return: The required rate of return is the return that investors expect to earn on the stock. It is typically calculated using the Capital Asset Pricing Model (CAPM).

  • Growth Rate: The growth rate of dividends is based on the company’s earnings growth, its return on equity (ROE), and its retention ratio (the portion of earnings not paid out as dividends).

    • g = ROE × Retention Ratio

PreviousNext