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Dividend Discount Model

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8 views

Dividend Discount Model

Uploaded by

vladspersonaluse
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Dividend Discount Model

One of the first models used for pricing stocks was developed by John B.
Williams in
1931. This model is still applicable today. Williams stated that the price of a
stock should
reflect the present value of the stock’s future dividends, or

The model can account for uncertainty by allowing Dt to be revised in


response to
revised expectations about a firm’s cash flows or by allowing k to be revised
in response
to changes in the required rate of return by investors.

EXAMPLE:

To illustrate how the dividend discount model can be used to value a stock,
consider a stock that is expected to pay a dividend of $7 per share annually
forever. This constant dividend represents a perpetuity, or an annuity that
lasts forever. Hence the present value of the cash flows (dividend payments)
to investors in this example is the present value of a perpetuity. Assuming
that the required rate of return (k) on the stock of concern is 14 percent, the

present value (PV) of the future dividends is

Unfortunately, the valuation of most stocks is not this simple because their
dividends are
not expected to remain constant forever. If the dividend is expected to grow
at a constant rate, however, the stock can be valued by applying the
constant-growth dividend discount model:

where D1 is the expected dividend per share to be paid over the next year, k
is the
required rate of return by investors, and g is the rate at which the dividend is
expected
to grow. For example, if a stock is expected to provide a dividend of $7 per
share next
year, the dividend is expected to increase by 4 percent per year, and the
required rate of
return is 14 percent, the stock can be valued as

Relationship with PE Ratio for Valuing Firms The dividend discount model and
the PE ratio may seem to be unrelated, given that the dividend discount
model is highly dependent on the required rate of return and the growth rate
whereas the PE ratio is driven by the mean multiple of competitors’ stock
prices relative to their earnings expectations and by the earnings
expectations of the firm being valued. Yet the PE multiple is influenced by the
required rate of return on stocks of competitors and the expected growth
rate of competitor firms. When using the PE ratio for valuation, the investor
implicitly assumes that the required rate of return and the growth rate for
the firm being valued are similar to those of its competitors. When the
required rate of return on competitor firms is relatively high, the PE multiple
will be relatively low, which results in a relatively low valuation of the firm for
its level of expected earnings. When the competitors’ growth rate is
relatively high, the PE multiple will be relatively high, which results in a
relatively high valuation of the firm for its level of expected earnings. Thus,
the inverse relationship between required rate of return and value exists
when applying either the PE method or the dividend discount model. In
addition, there is a positive relationship between a firm’s growth rate and its
value when applying either method.
Limitations of the Dividend Discount Model The dividend discount model may
result in an inaccurate valuation of a firm if errors are made in estimating the
dividend to be paid over the next year or in estimating the growth rate or the
required rate of return by investors. The limitations of this model are more
pronounced when valuing firms that retain most of their earnings, rather
than distributing them as dividends, because the model relies on the
dividend as the base for applying the growth rate. For example, many
smaller publicly traded firms that are attempting to grow retain all earnings
to support growth and thus are not expected to pay any dividends.

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