Discounted Dividend

Model

BY:
DHEERAJ MAHAJAN (19 -MBA-16)
KOMAL GUPTA (30 -MBA-16)
PRIYANKA SHASHU(44 -MBA-16)
SUMEET KOUR (62-MBA-16)
Theory of Valuation

To convert the estimated stream of returns to a

value for security, the stream must be discounted
at the required rate of return
Process of Valuation requires estimates of:
The stream of expected returns
The required rate of return on the investment
Stream of Expected Returns
(Cash Flows)

Forms of Returns: they may be earnings, cash

flows, dividends, interest payments or capital
gains.

Time Pattern and Growth rate of Returns:

estimation of when to receive the returns and
growth rate of return from investment
Required Rate of Return

Uncertainty of Returns: All investments are

affected by the risk-free rate and the expected rate
of inflation, as they determine the nominal risk-
free rate
Investment Decision Process

If Estimated Intrinsic Value > Market Price, Buy or

Hold it if you own it

If Estimated Intrinsic Value < Market Price, Dont

Buy or Sell it if you own it
 Approaches to Equity Valuation

Discounted Cash Flow Relative Valuation

Techniques Techniques

Present Value of
Price/Earning Ratio (P/E)
Dividends (DDM)

Present Value of Operating Price/Cash Flow Ratio

Free Cash Flow (P/CF)

Present Value of Free Cash Price/Book Value Ratio

Flow to Equity (P/BV)

Price/Sales Ratio (P/S)

Why and When to Use DDM

The Straight Forward measure of Cash Flow is

Dividends
Uses Cost of Equity as the Discount Rate
Useful for discussing valuation for a stable, mature
entity, where assumption is constant growth of
dividends.
Discounted Cash Flow Valuation
Technique

Where:
Vj = Value of Stock j
n = life of an asset
CFt = cash flow in period t
k = the discount rate that is equal to the investors required
rate of return for Asset j, determined by the uncertainty (risk)
of the assets cash flows
The Dividend Discount Model
(DDM)

Where:
Vj = Value of Stock j
Dt = dividend during Period t
K = required rate of return on Stock j
If stocks are sold after 2 Years

SPj2 = Sale price of Stock J at the end of 2 years

 INFINITE PERIOD DDM
Assume that the future dividend stream will grow at a constant
rate, g, for an infinite period, that r is greater than g, and that D1
is the dividend to be received at the end of period 1, then

V0 = D1/ r-g
 The process of estimating the inputs to
be used in infinite period DDM:
ESTIMATING THE REQUIRED RATE OF RETURN:
1. ESTIMATING THE REAL RISK FREE RATE
2. ESTIMATING THE EXPECTED RATE OF
INFLATION
3.CALCULATING THE NOMINAL RISK FREE
RATE:
(1+ REAL RISK-FREE RATE)*(1+ EXPECTED RATE
OF INFLATION)-1.
4.ESTIMATING THE RISK PREMIUM OF THE
STOCK.
5.CALCULATE THE REQUIRED RATE OF RETURN
 ESTIMATING THE DIVIDEND
GROWTH RATE
ESTIMATE THE FIRMS RETENTION RATIO
ESTIMATE THE FIRMS EXPECTED RETURN ON EQUITY
CALULATE THE DIVIDEND GROWTH RATE:
RETENTION RATE (b) * return on equity (ROE)
THE INFINITE PERIOD DDM HAS
4 ASSUMPTIONS:
The stock pays dividend
Dividend grow at a constant rate (g)
The constant growth rate will continue
forever.
The required rate of return is greater than
the growth rate; otherwise the model
breaks down since the denominator is
negative.
GROWTH COMPANIES
These are the companies that have the
opportunities and abilities to earn rate of return
on investments that are consistently above their
required rate of return.

Here, the higher growth rate cannot be

maintained forever, and the growth rate
probably exceeds the required rate of return.
 APPLYING DDM VALUATION MODEL
TO
THE MARKET
When we apply the DDM, it estimates the value of the stock
(Vj),assuming a constant growth rate of dividends for an infinite period.

Vj = D1(1+g) / (1 + k) + D2(1 + g)2 / (1 + k)2 + . .

+ Dn(1 +k)n/ (1 +k)n

Vj= value of stock j

D0= the dividend payment in the current period
g= the constant growth rate of dividends
k=the required rate of return on stock j
n=the number of periods, which is assumed to be infinite
 This model which can also be used extensively
for the fundamental analysis of a common
stock, can also be used to value a stock market
series.
Vj = Pj = D1 / (k - g)

This model suggests that the parameter to be

estimated are
1. The required rate of return (k)
2. The expected growth rate of dividends (g)
After estimating g, it is simple to estimate d1
because it is equal to the current dividend
(D0) times (1+g)