In this lesson we are teaching you how to price stocks using the Dividend Discount Model (DDM). We explain the concept of the dividend discount model (DDM) and show you the necessary assumptions along with how to get the cost of equity (discount rate) using the Capital Asset Pricing Model CAPM. We also teach you the constant growth dividend discount model and then show you how to tailor the dividend discount model according to the what is expected of the company in the future.
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How do you determine the present value to pay for the company's share, if there are multiple growth rates? For example; a company has just paid a dividend of $80 per share and forecasts that its earnings and dividends are expected to grow at an annual rate of 5% over the next four years. Thereafter, earnings and dividends are expected to grow at an annual rate of 6% for the foreseeable future. If we require a rate of return of 20%, how much would we pay for each share in this company?
It depends if it is temporary or a more permanent decision. If it's temporary, you need to assume how long the company wants to preserve capital before raising its distribution again. If permanent, probably due to cyclical changes in industry or legislation, you shouldn't be using the model because the DDM is tailored for more stable companies with consistent track records.
This is because your growth is with respect to 100% of your existing investment value. Say for example you have $100 in a savings account, and the bank is paying 2% annually. You can calculate the future value of time period 1 by: $100 today = 100 X (1+0.02) = $102 the next year. Make sense?
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Very nice presentation. One comment though: in the book of Brearly & Myres, we don't need to plug in the terminal value of stocks (future price of stock) in the model since in theory, this will become zero while dividend will account for all cash flow to the investor. Thus you can use just the model for discounting of bonds in perpetuity to the value of the stocks. This simply is the dividend discount model.
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