Module 41.2: Dividend Discount Model

Question 1

What is the dividend discount model?

Answer 1

based on the rationale that the intrinsic value of a stock is the present value of its future dividends.

Question 2

What is the formula for the dividend discount model?

Answer 2

sum of Dt / (1 + ke) ^ t

Dt = dividend at time t
ke = required rate of return on common equity

Question 3

What is the formula for a one year holding period DDM?

Answer 3

(dividend to be received / 1 + ke) + (year-end price / 1 + ke)

Question 4

What is the formula for a multiple-year holding period DDM?

Answer 4

value = D1 / 1(+ke) + D2 / (1+ke)^2 + P2 / (1+ke)^2

P2 = terminal value

Question 5

How can free cash flow of equity be calculated?

Answer 5

FCFE = net income + depreciation - increase in working capital - fixed capital investment - debt principal repayments + new debt issues

FCFE = cash flow from operations - FCInv + net borrowing

Question 6

What is the formula to calculate value of a fixed dividend preferred equity that is infinite.

Answer 6

Dp / Kp

Dp = dividend
Kp = required rate of equity

Question 7

What is the Gordon growth model?

Answer 7

assumes the annual growth rate of dividends is constant. requires growth rate and dividend rate to never change. ke must be greater than gc.

formula is D1 / Ke - gc

gc = growth rate

Question 8

What happens if the difference between ke and gc widens?

Answer 8

the value of the stock falls.

Question 9

How can an analyst determine the growth rate in dividends?

Answer 9

1) use the historical growth in dividends for the firm
2) use the median industry dividend growth rate
3) estimate the sustainable growth rate

Question 10

What is the sustainable growth rate for dividends and how is it calculated?

Answer 10

sustainable growth rate is the rate at which equity, earnings, and dividends can continue to grow indefinitely assuming that ROE is constant.

sustainable growth =1 (1 - dividend payout ratio) x ROE

Question 11

What are the steps of a multistage DDM?

Answer 11

1) determine the discount rate
2) project the size and duration of the high initial dividend growth rate
3) estimate dividends during the high-growth period
4) estimate the constant growth rate at the end of the high-growht period
5) estimate the first dividend that will grow at constant rate
6) use the constatn growth value to calculate the stock value
7) add the PVs of all dividends to the PV of the terminal value of the stock.