When an investor buys stock, she generally expects to get two types of cash flows - dividendsduring the period she holds the stock and an expected price at the end of the holding period. Sincethis expected price is itself determined by future dividends, the value of a stock is the present valueof dividends through infinity.The rationale for the model lies in the present value rule - the value of any asset is the present valueof expected future cash flows discounted at a rate appropriate to the riskiness of the cash flows.There are two basic inputs to the model - expected dividends and the cost on equity. To obtain theexpected dividends, we make assumptions about expected future growth rates in earnings and payout ratios. The required rate of return on a stock is determined by its riskiness, measureddifferently in different models - the market beta in the CAPM, and the factor betas in the arbitrageand multi-factor models. The model is flexible enough to allow for time-varying discount rates,where the time variation is caused by expected changes in interest rates or risk across time.
2. Versions of the model
Since projections of dollar dividends cannot be made through infinity, several versions of the dividend discount model have been developed based upon different assumptions aboutfuture growth. We will begin with the simplest – a model designed to value stock in a stable-growthfirm that pays out what it can afford in dividends and then look at how the model can be adapted tovalue companies in high growth that may be paying little or no dividends.
I. The Gordon Growth Model
The Gordon growth model can be used to value a firm that is in 'steady state' with dividendsgrowing at a rate that can be sustained forever.
The Gordon growth model relates the value of a stock to its expected dividends inthe next time period, the cost of equity and the expected growth rate in dividends.