CYPRUS INTERNATIONAL UNIVERSITY

ULUSLARARASI KIBRIS ÜNIVERSITESI

Faculty of Economics and Administrative Sciences

Business Administration Department

Financial Management Term Project

EASC346

TITLE

COMPARATIVE ANALYSIS OF DIVIDEND DISCOUNT

MODEL AND STOCK MULTIPLES

Presented by JOSEPH BAMBOTE 22102711

Date: Monday, 27 May 2024

Spring 2023
1. Introduction to Dividend Discount Model (DDM)
1.1. Explanation of DDM
The DDM is undoubtedly the simplest approach to equity valuation. It is actually a
technique to estimate a company's stock intrinsic value relying on the idea that a share's
current worth is the summation of all its future dividends (and the stock's selling price if sold),
discounted to their present value. One of the advantages of this model is that it takes into
consideration the time value of money when comparing an investment's profit and cost,
making it particularly useful and realistic.
1.2. Formula and Components
As commonly understood, investors expect two types of cash flows when they purchase a
stock: dividends received during the holding period, and the selling price of the stock when it
is sold. So, given that the model relies on the present value principle, as mentioned earlier, the
stock's price over a period of n years will then be equal to the total of the present value of
expected dividends plus the selling price at the end of the nth year, all discounted over n
years, plus the selling price at the end of the nth year.
𝑫𝟏 𝑫𝟐 𝑫𝒏 𝑷𝒏
𝑷𝟎 = + 𝟐
+ ⋯+ 𝒏
+
(𝟏 + 𝒌) (𝟏 + 𝒌) (𝟏 + 𝒌) (𝟏 + 𝒌)𝒏
Given that the initial price of a stock is found using discounted future dividends, this
simply means that the present value of a stock held for infinity will be:
𝑫𝟏 𝑫𝟐 𝑫∞
𝑷𝟎 = + + ⋯ +
(𝟏 + 𝒌) (𝟏 + 𝒌)𝟐 (𝟏 + 𝒌)∞
∞
𝑫𝒏
𝑷𝟎 = ∑
(𝟏 + 𝒌)𝒏
𝒏=𝟏

 𝑫𝒏 - Expected dividend in period n, and

 𝒌 – Required rate of return.
As the formula above illustrates, the model encompasses two basic intakes:
 The expected dividends which are obtained by making estimations about future
growth rates and,
 The required rate of return which is a function of its risk measured differently
depending on the model. For instance, the market beta in the Capital Asset Pricing
Model (CAPM) is used in majority of cases.
Versions of the model
The inability to project dividends through infinity has led to various versions of the DDM
based on different assumptions of future growth.
 A. DDM with zero-growth
A simplified version of the model whose assumption is that dividends will be constant
forever (𝑫𝟏 = 𝑫𝟐 = ⋯ = 𝑫𝒏 ). The stock’s present value Po will be the discounted amount of
dividends but this time, in perpetuity.
𝑫
𝑷𝟎 =
𝒌
Where,
 𝑫 = Constant dividend
B. The Gordon Growth Model (GGM)
Named after Myron J. Gordon, it is the most widely used version of the DDM. It
postulates that dividends grow at a fixed and indefinitely sustainable rate, that’s why it is also
called (The Constant Growth Model). The GGM values a firm by calculating prices of stock
relying on the perpetual constant growth of dividends, considering the stock is held by the
investor forever. (Gordon, 1959; Gordon and Shapiro, 1956).
Thus, Po can be determined as follows:
𝑫𝟎 × (𝟏 + 𝒈) 𝑫𝟏
𝑷𝟎 = =
𝒌−𝒈 𝒌−𝒈
Components:
 𝑫𝟎 = Dividend just paid at the beginning of the period
 𝑫𝟏 = Dividend expected in the next period (period 1)
 𝒌 = Required rate of return, where 𝒌 > g
 𝒈 = Constant growth rate
This model remains flexible in that we can use it to get the stock price at any time, not just
today. Indeed, the share price at time t is:
𝑫𝒕 × (𝟏 + 𝒈) 𝑫𝒕+𝟏
𝑷𝒕 = =
𝒌−𝒈 𝒌−𝒈
This derivative is called Dividend Growth Model
C. Nonconstant Growth DDM
This scenario is also important because it accounts for "supernormal" growth rates over a
limited period. As previously stated, the growth rate cannot surpass the required return
indefinitely, but in some cases, it actually can for several years. So, to simplify the laborious
and avoid forecasting and discounting an infinite number of dividends, we assume that
dividends will begin growing at a constant rate at some point in the future.
𝑫𝟏 𝑫𝟐 𝑫𝒏 𝑷𝒏
𝑷𝟎 = + + ⋯ + +
(𝟏 + 𝒌) (𝟏 + 𝒌)𝟐 (𝟏 + 𝒌)𝒏 (𝟏 + 𝒌)𝒏
 𝑫𝒏 ×(𝟏+𝒈)
Where, 𝑷𝒏 =
(𝒌−𝒈)

1.3. Assumptions and Limitations

1. Constant or predictable dividend growth: The DDM postulates that dividends are
stable, or grow at a constant rate forever. This is the big and not realistic assumption
this model makes. Indeed, it is almost impossible to know with precision what
the dividend figure will look like in the upcoming years, much less a dozen years from
now.
2. Dividends as the Sole Source of Value: The stock value is derived only from the
present value of future dividends. In addition, any capital gains shareholders realize
are presumed to come from reinvested dividends. This highlights the importance of
dividend income in assessing a stock's intrinsic value.
3. Stable economic and market conditions: The DDM assumes “ceteris paribus.” It
shortens the evaluation process by considering that factors such as interest rate,
inflation, etc. will remain constant or follow predictable trends. However, this is not
the case, especially in dynamic economic environments where external factors can
significantly impact dividend growth and discount rates.
4. No change in capital structure: The model supposes that the capital structure
remains constant, ignoring potential changes such as issuing debt securities or
repurchasing shares. Thinking this way simplifies the valuation, but at the same time,
it overlooks major changes that could affect the cost of capital and the discount rate,
impacting shareholder value.
5. The DDM is limited to companies that pay dividends.
6. Sensitivity to Input Variables: Indeed, the DDM is very sensitive to variation in
growth rate and discount rate. A small change or error in writing these values can
really affect the stock valuation.

2. Introduction to Stock Multiples

2.1. Explanation of Stock Multiples
Stock multiples are a financial analysis tool used to evaluate a company's value in relation
to its financial performance and market peers. Unlike the Dividend Discount Model (DDM),
which centers on dividends as the main value indicator, stock multiples, also known as
valuation multiples or simply multiples, use various financial metrics to determine a
company's value. Essentially, stock multiples are ratios comparing a company's stock price to
a specific operational metric.
2.2. Types of Stock Multiples
There are two main types of stock multiples:
a. Equity multiples, Equity multiples consist of analyzing ratios between a company's
stock price and various performance indicators, such as book value, sales, and
earnings. Some of these ratios are:
 Price-to-Earnings: Divides the price per share by the earnings per share. It is
undoubtedly one of the most utilized.
  Price-to-Book: Divides the price per share by the book value (Book value or Equity =
Total Assets - Total Liabilities) per share.
 Price-to-Sales: Divides the price per share by the sales revenue per share. It is
especially applied in case where companies are dealing with low or negative earnings
but high revenue.
b. Enterprise Value multiples

 EV to Earnings Before Interest, Taxes, Depreciation and Amortization: Divides

the Enterprise Value by the EBITDA.
 EV to Earnings Before Interest and Taxes: Divides the Enterprise Value by the
EBIT.
 EV to Sales: : Divides the Enterprise Value by its sales revenue
N.B: EV=Market Capitalization + Total Debt − Cash and Cash Equivalents
2.3. Application and Interpretation
Stock multiples are applied in various ways in financial analysis:
 Relative Valuation: Valuations multiples are utilized for comparing a company's
value to its industry concurrents. A company with lower multiples than its peers may
be considered undervalued, while one with higher multiples may be overvalued.
 Benchmarking: Multiples provide benchmarks for evaluating a company's
performance over time. Changes in multiples can indicate shifts in investor sentiment,
changes in financial performance, or shifts in industry dynamics.
 Forecasting: Analysts use stock multiples to predict future stock prices based on
expected changes in financial metrics.
Interpreting multiples requires the consideration of industry trends, growth potential, and
risks. A high multiple may indicate strong growth but also higher risk, while a low multiple
may suggest undervaluation but could also signal underlying issues or lack of growth
prospects.

3. Comparative Analysis
3.1. Strengths and Weaknesses of DDM
Strengths:
 There is no vagueness concerning the definition of dividends. Dividends are
consistently defined regardless of the country or region, in contrast to cash flow or
earnings, which can be understood and interpreted in various ways. This guarantees
consistency of independent assessments using the DDM.
 The DDM is based on the fundamental principles of finance, especially the time value
of money. It provides a theoretically sound framework for valuing dividend-paying
stocks.
  It enables valuation independent from current market conditions by considering that
factors such as interest rate, inflation, etc. are constant.
Weaknesses:
 The DDM is limited to companies that pay dividends.
 As stated previously, the DDM is very sensitive to variation in growth rate and
discount rate.
 The assumption of perpetual, constant growth is literally unrealistic.
3.2. Strengths and Weaknesses of Stock Multiples
Strengths:
 Valuation multiples is relatively easy to understand. This is because the information
required is minimal and can be easily calculated, making it easier for investors and
analysts to use.
 Ratios and industry benchmarks provide valuable insights into relative performance.
 Applicable to all companies without limitations.
Weaknesses:
 Stock multiples are based on market prices, influenced by factors such as market
sentiment, investor perception, etc. thus leading to potential valuation distortions.
 They provide an estimated company's value and may not reflect all relevant factors
influencing valuation, such as growth prospects or risk factors.
 The accuracy of multiples depends on the availability and comparability of peer
companies whose benchmarks may vary across industries and market segments.
3.3. Differences in Assumptions and Inputs
The DDM and stock multiples have different assumptions and different required inputs:
 The DDM relies on assumptions about dividend growth rates and the rate of return,
which may be laborious to estimate precisely.
 Stock Multiples depend on various operating metrics, such as earnings, book value, or
sales, each of which may provide different perspectives on valuation.
3.4. Applicability in Different Market Conditions
The suitability of DDM and stock multiples may vary depending on market conditions:
 The DDM is mostly suitable for stable market conditions and companies with
predictable dividend growth rate, where the assumptions of perpetual growth are more
likely to be true and realistic.
 Stock Multiples however are more versatile and adaptable to changing market
conditions since they rely on current market prices and financial metrics.
4. Conclusion
4.1. Summary of Findings
The dividend discount model (DDM) and stock multiples are distinct approaches to stock
valuation, each based on different theoretical underpinnings. The first relies on assumptions
about dividend growth rates and rates of return to calculate the value of a stock using
discounted future dividends. The second is based on the current market data using current
market prices and various financial metrics (earnings, book value, sales revenue…)
Each method has its positive and negative aspects. The DDM's emphasis on long-term
value and stability makes it effective for evaluating dividend-paying companies, but its
reliance on assumptions of constant dividend growth limits its applicability. Stock multiples
are simpler and more accessible, allowing easy comparisons between companies. However,
they may lack accuracy and be influenced by market sentiment, which can lead to potential
valuation errors.
The suitability of each method relies upon market conditions and characteristics of the
business. The DDM works well for stable companies with predictable dividend growth,
providing a reliable measure of intrinsic value in stable markets. Stock multiples, which are
more adaptable and easier to use, perform better in dynamic markets where industry
conditions and market sentiment are crucial.
4.2. Recommendations for practical use
 For Long-Term Investors: The DDM is ideal for those focused on the long-term
value of dividend-paying stocks. It helps estimate intrinsic value and spot
opportunities in stable companies.
 For Short-Term Traders: Stock multiples are great for short-term traders looking to
take advantage of market inefficiencies or trends. They allow quick comparisons with
peers and industry norms.
 Combining Methods: Using both methods together can provide a fuller picture. Stock
multiples can be used for initial screening, followed by the DDM for deeper analysis,
leading to better investment decisions.
 Consider Market Conditions: It's important to consider market conditions. The
DDM works well in stable markets, while stock multiples are more useful in volatile
or rapidly changing environments.
References
Ross, S. A., Westerfield, R. W., Jordan, B. D., & ROBERTS, G. S. (1998). Fundamentals
of. Corporate Finance.
Kulwizira Lukanima, B. (2023). Dividend Discount Models. In Corporate Valuation: A
Practical Approach with Case Studies (pp. 559-583). Cham: Springer International
Publishing.
Erdoğan, E. (2010). Firm value, cost of equity and application in some Turkish
companies (Master's thesis, Sosyal Bilimler Enstitüsü).
Farrell Jr, J. L. (1985). The dividend discount model: A primer. Financial Analysts
Journal, 41(6), 16-25.
Penman, S. H. (1998). A synthesis of equity valuation techniques and the terminal value
calculation for the dividend discount model. Review of accounting studies, 2, 303-323.