Equity Valuation - Dividend Discount Model

The analyst can use a variety of models to estimate the intrinsic value of equities. One such model is the Dividend Discount Model. Under this model the value of a stock is calculated as the present value of all future dividends from the stock.

As you can see in the above video, the general form of the model shows that the stock value is equal to the present value of all cash flows, where D is the dividend for each period, k is the required rate of return on common equity, and V is the current stock value. Calculating the value of stock using this formula is impractical as we cannot determine the dividends for each period till infinity. A normal assumption is that an investor will hold the asset for a period and then sell it. With such an assumption, it becomes easy to calculate the stock value.

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.