Posted: March 6th, 2023
The Dividend Discount Model (DDM) is a method used to estimate the intrinsic value of a company’s stock. The DDM works by discounting all future dividends of a company at an appropriate cost of equity and summing them up to calculate the present value, which is then compared to the current market price of the share. There are three different models that can be used within this framework: Constant Dividend (Zero growth), Constant Growth, and Nonconstant Growth.
Constant Dividend (Zero-Growth) Model
This model assumes that there will be no change in dividends over time; therefore, it estimates only one dividend payment and discounts it with an appropriate cost of equity for an infinite amount of periods or until perpetuity. While this does not accurately portray how dividends work in reality due to their fluctuating nature, it helps provide investors with a starting point for analyzing stocks as it simplifies and makes assumptions about future cash flows from dividends. It also functions as an anchor when compared against growth or nonconstant models (Santiago & Valdes-Perez, 2017).
Calculating fair values using this model requires knowledge on how much will be paid out per period along with the required rate of return. The formula used is simply PV0=D1/r where PV0 stands for Present Value at time 0; D1 is dividend per period expected; r represents required rate of return expressed as a decimal form instead of percentage form(Lorenzo et al., 2018).
Constant Growth Model
The constant growth model assumes that dividend grows at some constant compounded annual rate g forever into perpetuity while its payout ratios remains unchanged over time(Peterson & Fabozzi, 2014). This would mean an increased but steady level payout rather than having sudden jumps in dividend payments that occur more frequently seen in reality. Because most companies already have set historical rates which they follow yearly or quarterly payments are made under predetermined ratio policies(Nissim& Penman 2001); therefore it may offer more accurate measurements than zero-growth models by allowing investors to factor real world scenarios into their calculations.
Calculating fair values using constant growth model requires knowledge on initial dividend payment plus anticipated growth rate along with the required rate return . This can be calculated using Gordon’s formula: PV = D0 × 1 + g / R – g where PV stand for Present Value at time 0;D0 stands for Initial Payment ,R denotes Required Rate Of Return ;g denotes Annual Growth Rates(Bodie et al., 2009).
Nonconstant Growth Model
Nonconstant growth models are more complex methods utilized when trying to evaluate stocks since they assume both growing and decaying phases throughout any given investment timeline often referred to as multi-stage models because each phase may require separate input parameters such as varying levels or rates depending on what stage its currently in (Melicher& Norton 2008). These types DDMs allow investors greater flexibility when analyzing potential investments since they take changing economic conditions into account whereas other forms remain somewhat static even during turbulent times creating distortion between estimated returns versus actual returns achieved after taking risk premiums into consideration such as inflationary factors etc.. Additionally this provides better accuracy since changes caused due external influences can better forecasted without too little discrepancies between predicted figures versus reality thereby resulting higher chances success investing particular firm’s shares .
In order determine stock prices through calculation adjusted present valuation firstly need identify numerous stages which its expected grow decay secondly appropriately assigned inputs associated each respective stages like start end points initial final values specific phases . Finally data gathered gets plugged equations ascertain current market price discounting all projected cash flow according user specified inputs variables previously mentioned regarding various points development cycle proceeds until reach desired outcome figure representing true worth asset question based aforementioned parameters assuming reasonable inflation premium incorporated equation give insight related actual net worth individual security being evaluated relation truth (Graham & Harvey2001 ).
In conclusion ,the three most common DDMs discussed include Constant Dividend Zero-Growth ,Constant Growths and Nonconstant Groth Models Each have different applications depending scenario investor has mind making requirements selecting tool apply relevant situation reasonably accurate result obtained fairly quickly especially these days available software technologies dealing analytical tasks easily affordably much less cumbersome manual calculations via spreadsheet programs such Microsoft Excel lot easier nowadays tackle problems finance industry given rise new digitalized platforms technological advancements providing support access right resources solve complicated tasks ease.(Kaminsky2015)
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