Multi-stage Dividend Discount Models

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.

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

Here, P_n is calculated using the Gordon Growth Model formula:

$=\frac{D_{n+1}}{k-g}$

Example

Let’s take a simple example to understand this:

Assume that a stock that pays dividends is expected to grow at a high rate of 15% per year for the first 3 years, after which it will grow at 6% per year.

The last dividends pay were $1, and the required rate of return in 8%.

Let's see how multi-stage growth model can be used to value this stock.

First we will calculate the dividends in the high growth period.

D1 = 1*1.15 = $1.15

D2 = 1.15*1.15 = 1.3225

D3 = 1.3225*1.15 = 1.521

Note that after D3, the dividends are expected to grow at a constant growth rate of 6%. So, D3 will grow at a constant rate of 6%. We can use D3 and the constant growth rate to calculate P2, that is, the value of the stock at t=2.

P2 = D3/(k-g) = 1.521/(8% - 6%) = 76.05

The present value of the stock will now be the sum of D1, D2, and P2.

V0 = 1.15/(1.08) + 1.3225/(1.08)^2 + 76.05/(1.08)^2

= 67.34

Note that you could also calculate D1, D2, D3, and P3 and then take the present value of all these to arrive at the value of the stock. The answer will be the same.