15.2 Dividend Discount Model (DDM)

Value of stock under DDM

\[\begin{equation} V_0 = \dfrac{\mathrm{E}[Div_1]}{k - g} \tag{15.2} \end{equation}\]

  • \(Div_1\) is paid at the end of year 1

  • Constant growth assumption where \(\mathrm{E}[Div_i] = \mathrm{E}[Div_0] \cdot (1+g)^i\)

  • \(\mathrm{E}[Div_1] = (1 - \rho) NI\)

Remark.

  • Typically forecast a few years and use the above formula for the terminal value

  • Need to use \(NI\) after tax

  • When calculating \(g\), calculate \(ROE\) and \(g\) for all years and make selection

  • Firm with high expected growth tend to be riskier \(\Rightarrow\) Higher discount rate

    • Forecast is more susceptible to being wrong, so should be discount more?

DDM Assumptions

  • Expected dividends (however they are discretionary)

  • Dividend growth rate (from table 15.1)

  • Risk-adjusted discount rate (From CAPM)