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Dividend Discount Model

Dividend Discount Model

It is a financial model that values shares at the discounted value of the future dividend payments. The model  provides a means of developing an explicit expected return for the market. Since shares are valued on the actual cash flows received by the investors, it is theoretically the correct valuation model. Under this model, the price a share will be traded is calculated by the net present value of all expected future divided payment discounted by an appropriate risk-adjusted rate. This dividend discount model price is the intrinsic value of the stock. If the stock pays no dividend, then the expected future cash flows is the sale price of the stock. The security with a greater risk must potentially pay a greater rate of return to induce investors to buy the security. The required rate of return (capitalization rate) is the rate of return required by investors to compensate them for the risk of owning the security. This capitalization rate can be used to price a stock as the sum of its present values of its future cash flows in the same way that interest rates are used to price bonds in terms of its cash flows. The price of a bond is the sum of the present value of its future interest payments discounted by the market rate. Similarly, the dividend discount model (DDM, dividend valuation model, DVM) prices a stock by the sum of its future cash flows discounted by the required rate of return that an investor demands for the risk of owning the stock. Future cash flows include dividends and the sale price of the stock when it is sold. This DDM price is the intrinsic value of the stock. If the stock pays no dividend, then the expected future cash flow is the sale price of the stock.

Intrinsic Value = Sum of Present Value of Future Cash Flows

Intrinsic Value = Sum of Present Value of Dividends + Present Value of Stock Sale Price

There are 3 models used in the dividend discount model:

a. Zero-growth, which assumes that all dividends paid by a stock remain the same.

b. Constant-growth model, which assumes that dividends grow by a specific percent annually.

c. Variable-growth model, which typically divides growth into 3 phases: a fast initial phase, then a slower transition phase that ultimately ends with a lower rate that is sustainable over a long period.

a. Zero-Growth Rate DDM: Since the zero-growth model assumes that the dividend always stays the same, the stock price would be equal to the annual dividends divided by the required rate of return.

Stock’s Intrinsic Value = Annual Dividends / Required Rate of Return

Dividend Discount Model

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