Dividend Discount Model

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CHAPTER 13

DIVIDEND DISCOUNT MODELS

In the strictest sense, the only cash flow you receive from a firm when you buy

publicly traded stock is the dividend. The simplest model for valuing equity is the dividend

discount model -- the value of a stock is the present value of expected dividends on it. While

many analysts have turned away from the dividend discount model and viewed it as

outmoded, much of the intuition that drives discounted cash flow valuation is embedded in

the model. In fact, there are specific companies where the dividend discount model remains

a useful took for estimating value.

This chapter explores the general model as well as specific versions of it tailored for

different assumptions about future growth. It also examines issues in using the dividend

discount model and the results of studies that have looked at its efficacy.

The General Model

When an investor buys stock, she generally expects to get two types of cashflows dividends during the period she holds the stock and an expected price at the end of the

holding period. Since this expected price is itself determined by future dividends, the value

of a stock is the present value of dividends through infinity.

t =∞

Value per share of stock =

E(DPSt )

∑ (1 + k )

t =1

t

e

where,

DPS t = Expected dividends per share

ke = Cost of equity

The rationale for the model lies in the present value rule - the value of any asset is the

present value of expected future cash flows discounted at a rate appropriate to the riskiness

of the cash flows.

There are two basic inputs to the model - expected dividends and the cost on equity.

To obtain the expected dividends, we make assumptions about expected future growth rates

in earnings and payout ratios. The required rate of return on a stock is determined by its

riskiness, measured differently in different models - the market beta in the CAPM, and the

factor betas in the arbitrage and multi-factor models. The model...