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Dividend Discount model

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The Dividend Discount model (DDM) is a method of valuing a company’s stock price based on the assumption that the company estimate the current fair price of a stock equals the sum of all of the company future dividends discounted based on present value. The market value of a company shares are discounted projected dividends of the company at the rate of return required by investors.

Dividend Discount Model(DDM) uses the concept of the time value of money and present values of future dividends. It assumes that the same amount of dividend is paid annually, and the most recent dividend payment has recently been paid. Based on the variation of the dividend discount model, the company analyzes and forecasts future dividends payments, the growth of dividend payments, and the cost of equity capital.

Formula

Dividends which are not expected to grow over the years, the value of a share is calculated as follows:

Dividend value = d/re

Whereas,

D is the expected dividend for the year

Re the rate of return required by investors which is the same as the cost of equity.

Dividends which are expected to grow over the years, this approach also incorporate the expected growth rate in the following calculation:

Dividend value = d (1+g)/re-g

Whereas,

D and Re are same as above

G is the annul expected growth in dividends

The dividend discount mode has various variation based on the stated assumptions. It is calculated by using:

Gordon Growth Model(GGM)

One period dividend discount model

Multi-period dividend discount model

Gordon Growth Model(GGM)

It assumes that dividends will grow at some constant rate in future for an infinite time. GGM can be expressed as following ways:

V0 = D1 / r –g

Whereas;

V0= the current fair value of a stock

D1= the dividend payment in first period from current period

r= the estimated cost of equity capital (calculated using CAPM)

G = the constant growth rate of the company dividends for an infinite time

One period dividend discount model

It is less practice than GGM. When an investor wants to determine the intrinsic price of a stock that the company wills share in one period from now.

V0 = D1 /1+ r + P1 / 1 + r

Where P1 equals the stock price in one period from now

Multi-period Dividend discount model

It is update version of one period dividend discount model where an investors expects to hold a stock for the multiple periods.

V0 = D1 / (1+ r) + D2/ (1+ r) 2+…+ Dn/ (1+r) n+ pn/ (1+r) n

Example

Company has paid the dividend per share of $10. The rate of return required by the investors is 12%. Calculate the value of a share if the:

Expected growth rate is zero.

Dividend is expected to grow as 5 % annually

Solution:

Expected growth rate if zero:

V0=$10/12% = 83.33

Dividend is expected to grow as 5 % annually:

V0 = $10 * (1+5%)/ (12%-5%)

     = $150

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