Equity Valuation - Dividend Discount Model

The one year holding period DDM assumes that the investor holds the stock only for one year and then sells it at the end of the year. In this scenario, the current stock value can be calculated using the dividend discount model if we know how much dividend will be paid at the end of the year and at what price the investor will be able to sell the asset.

Let’s take a simple example. Assume that a stock paid $10 dividend last year and the next year’s dividend is expected to be 10% higher. At the end of the year, the stock will sell for $110. The investor has a required rate of return of 15%. The value of the stock will be the present value of these cash flows as shown on screen. Note that the dividend paid was $10 last year, and the dividend will grow by 10% next year. Therefore, D1 is taken as $11. Using the formula, the current value of the stock is $105.22.

In a multi-year holding period scenario, we assume that the investor holds the asset for multiple years before selling it. We calculate the value of the asset by adding the present values of all dividends for the holding period and present value of the estimated sale value of the stock at the end of the holding period.

On screen, you can see the formula for a 2-year holding period. Let’s take the same example but this time assume that the investor holds it for two years. The dividend continues to grow by 10%, and the investor is expecting to sell the stock for $115 after two years. Assuming a required rate of return of 15%, the current value of the stock will be $105.67.

One problem with the dividend discount model is that it cannot be used to value stocks that don’t pay dividends. In such cases the analysts use free cash flow to equity instead of dividends to calculate the present value.