Multi-stage Dividend Discount Models

In the previous articles, we learned about how a dividend discount model can be use to value a stock using the future cash flows.  However, in the constant growth model, we made an assumption that the dividends will grow at a constant rate. However, in reality this may not be the case. A firm may experience a period of very high growth and then after a few years, the growth rate may fall to a lower sustainable growth rate. In such a case we cannot apply the simple formula that we saw in the Gordon Growth Model that assumed a constant growth rate.

A stock with such characteristics can be valued by adding the present value of cash flows in the initial period of high growth and the present value of the stock after this high growth period assuming a constant growth rate.

$V_{0}=\frac{D1}{1+k}+\frac{D2}{\left ( 1+k \right )^{2}}+ \cdot \cdot \cdot +\frac{Dn}{\left ( 1+k \right )^{n}}+\frac{Pn}{\left ( 1+k \right )^{n}}$