Saturday, 29 April 2017

Dividend Discount Model

Present Value Models

Dividend Discount Model

1.  If a company pays regular dividends

The dividend discount model (DDM) values a share of common stock as the present value of its expected future cash flows (dividends).

When an investor sells a share of common stock, the value that the purchaser will pay equals the present value of the future stream of cash flows (i.e. the remaining dividend stream).

Therefore, the value of the stock at any point in time is still determined by its expected future dividends.

When this value is discounted to the present, we are back at the original dividend discount model.

2.  If a company pays no dividends currently

If a company pays no dividends currently, it does not mean that its stock will be worthless.

There is an expectation that after a certain period of time the firm will start making dividend payments.

Currently, the company is reinvesting all its earnings in its business with the expectation that its earnings and dividends will be larger and will grow faster in the future.

3.  If the company is making losses

If the company does not make positive earnings going forward, there will still be an expectation of a liquidating dividend.  

The amount of this dividend will be discounted at the required rate of return to compute the stock's current price.

Additional notes:

The required rate of return on equity is usually estimated using the CAPM.

Another approach for calculating the required return on equity simply adds a risk premium to the before-tax cost of debt of the company.

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