Advanced valuation
Dividend discount models
Value a share as the present value of its dividends, with the Gordon growth and two-stage models.
Learning objectives
- Value a share with the Gordon growth model, using next year's dividend
- Back out the cost of equity a share price implies
- Build a two-stage dividend discount model with a terminal price
- Explain when a dividend model fits better than an enterprise DCF
A shareholder receives two things: dividends while they hold the share, and a price when they sell. The buyer's price in turn depends on the dividends after that, so in the end a share is worth the present value of all its future dividends. That is the dividend discount model (DDM).
It is the natural model for companies whose dividends track their earning power: banks and insurers (where debt is part of the business, so an enterprise DCF and net-debt bridge don't fit), utilities and other mature, regulated payers. For a company that pays little or nothing today, the DDM says almost nothing useful — use an FCF-based DCF instead.
P₀ = D₁ ÷ (kₑ − g), where D₁ = D₀ × (1 + g)
- P₀
- value per share today
- D₀
- the dividend just paid (last 12 months)
- D₁
- the dividend expected next year
- kₑ
- cost of equity (e.g. from CAPM: r_f + β × ERP) — not WACC, because dividends belong to shareholders only
- g
- constant long-run dividend growth; must be below kₑ
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That's the last lesson in Company Valuation
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