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where
Po = the current stock price,
Dt = expected dividend in period t, and
r = the appropriate discount rate.
Although theoretically sound, the dividend discount model is not practical because it requires
the estimates of an infinite, or at least a very
long, dividend stream. In addition, it does not
allow for direct solution of the discount rate.
The more practical constant growth dividend
discount model greatly simplifies the problem
of estimating future dividends. It assumes that
dividends grow at a constant rate forever, so
that the price of a share of common stock may
be calculated as follows:
Po =
Current Models
The general dividend discount model states that
current stock price equals the present value of
all expected dividends. This is stated mathematically as:
(1)
.= . (1
Do(l + g)
(2)
r - g
where
Do = the dividend paid in the most recent 12
months and
Russell Fuller is Vice President of Conners iniKStor Services and Chi-Cheng Hsia is Professor of Finance at Washington State University.
(3)
+ PV (Phase 3),
as:
(1 + gn)'t - A
(1 + r)'
(5)
Do(l + ga)
I A-l
1 -
gn
1 + r
(6)
(8)
tk
ga
1
1
1
8b
gn
1
1
1
ga = 12%
gn = 8%,
r = 14%,
Do = $1.00, and
H = 5 years.
A + B
Do
(1 + gn) +
- gn)
(9)
$1.00
Po =
0.14 - 0.08
H-Model Features
The H-model has several pleasing features.
There are no exponential terms; solving for Po
involves only simple arithmetic. Also, to solve
analytically for the discount rate, the terms in
Equation (9) have only to be rearranged as
follows:
= ^
[(1 +
(10)
I0
If ga equals gn. Equation (10) reduces to Equation (3) of the constant growth model. In any
case, solving for r by Equation (10) is straightforward.
The H-model implies a growth rate pattern
over time that seems (to us at least) to be
plausible for many firms.* Figure E illustrates
the implicit pattern. The growth rate, beginning
at ga, declines in a steady fashion from ga to gn
over a period of 2H years. The growth rate is
halfway between ga and gn at year H and
reaches gn at the year 2H. (If ga is estimated to
be less than gn, then the line would slope
upwards toward gn over time.) This growth rate
pattern seems more likely than a two or threestep pattern (Figures C and D) with sudden
jumps from ga to gb to gn, and perhaps more
likely than the linear segments of the threephase model (Figure B).
5?^ . ,
8.1
.so
Sa + Sh
2
1
Sn
1 . ,
1.
1
1
1
1
1
1
H
11
1
> -
1
1
1
11
1
1
1
1
1)
13
211
DoH(ga - gn)
gn
Analysts should also find the H-model intuitively appealing. Suppose investors believe
that a firm's normal growth rate is equal to gn,
but believe that the firm currently has unusual
investment opportunities and therefore will
grow at an above-normal rate for the next 2H
years. In this case. Equation (9) of the H-model
indicates that the value of the stock is equal to
the capitalized value of the dividends assuming
normal growth (gn) plus the additional value
from the above-normal growth (ga). This interpretation becomes clearer if we rewrite Equation
(9) as follows:
Do(l
^^^ H-moiliI
$1.00(5)(0.12 - 0.08)
Po =
0.14 - 0.08
0.14 - 0.08
= 18.00 + 3.33 = $21.33.
1
1
1 t
2H
Case
No.
1
2
3
4
5
6
gu
7%,
12
12
-2
20
20
/I
9%
5yr.
5yr.
5yr.
3yr.
7yr.
3yr.
7yr.
7yr.
15 yr.
5yr.
13 yr.
7yr.
4%
4
4
4
4
4
Po
Ratio of
Estimated
Prices
6 yr.
6 yr.
10 yr.
4 yr.
10 yr.
5yr.
$24.40
30.40
36.80
16.00
52.80
36.80
0.98
0.98
1.02
1.07
1.29
1.03
H-Model
Three-Phase
Common Assumptions*
9
9
9
9
9
Po
$23.97
30.17
37.66
17.12
68.18
38.04
(12)
$3.44
$62
[(1.07) + 11(0.12-0.07)]
0.07 = 0.160.
^Beneficiar
220th Consecutive
Quarterly
Common Stock
Dividend
Common Stock
Quarterly $.50
Footnotes
5% Cumulative Preferred
Stock Semi annual $1.25
$4.50 Dividend Cumulative
Preferred Stock Semi-annual
-$2.25
May 23,1984
Beneficial corporation
Summer 1979.
HNANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1984 Q 5 5