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Colegio De San Juan De Letran

Accountancy

Equity Valuation
Dividend Discount Model-One year and Multi-year

Submitted to:

September 24, 2018

Submitted by:
Amargo, Angelique
Domingo, Jairus
Urbano, Jhimbo
Salentes, Leo
Ramos, Aaron
(Contributions at the last page)

Sources: © 2008, N. Lavanya and T. Malarvizhi

Originally published as a part of 2008 PMI Global Congress Proceedings – Sydney, Australia
https://www.fep.up.pt/disciplinas/PGI914/Ref_topico3/ProjectRAM_APM.pdf
Colegio De San Juan De Letran
Accountancy

The dividend discount model (DDM) is a method of valuing a company's stock price based on
the theory that its stock is worth the sum of all of its future dividend payments, discounted back
to their present value.
This model values common stock as the sum of the discounted Present Values of its estimated
cash flows. The model uses and estimates all future cash flows arising during the holding period.
The model treats the calculation of PV as if the equity was a fixed income instrument and the
equation looks as follows.

The dividend discount model (DDM) is a procedure for valuing a stock's price
by discounting predicted dividends to the present value.

If the value obtained from the DDM is higher than the current trading price of shares, then the
stock is undervalued.

Value of a Preferred Stock

Unlike common equity, preferred stocks pay a fixed dividend. As such, the value of a preferred
stock can be calculated using the dividend discount model. The value of the preferred stock is
essentially the present value of the dividend in perpetuity, where k is the required return.

k = Rate
Formula 1.1

Example: Calculating the value of a preferred stock

Assume that Newco's preferred stock pays out to an investor an annual dividend of \$8 per share.
Given a rate of return of 10%, what is the value of Newco's preferred stock?

\$8
Value of Newco's preferred stock = ( ) = \$80
.10

Sources: © 2008, N. Lavanya and T. Malarvizhi

Originally published as a part of 2008 PMI Global Congress Proceedings – Sydney, Australia
https://www.fep.up.pt/disciplinas/PGI914/Ref_topico3/ProjectRAM_APM.pdf
Colegio De San Juan De Letran
Accountancy

Value of a Common Stock

Much like a preferred stock, holders of common stock can also receive dividends. However,
dividends on common stock are not guaranteed, nor are they a fixed amount from year-to-year.
As such, we can value common stock using dividends over various time horizons.

1. One-year Holding period

Consider a one-year holding period, in this time frame, an investor will receive a dividend and
the price of the common stock at the end of the one year, both discounted back by the rate of
return on the common equity.

Keeping this in mind, we can calculate the value of the common stock as follows:

Formula 1.2

Example: Calculate the value of a stock with a 1-year holding period

Newco expects to pay its shareholders common equity, \$0.25 per share this year. The investor
anticipates Newco's stock will close the year at \$30 per share. Given a rate of return of 10%,
what is the value of Newco's common stock?

2. Multiple-year holding period

Given that investors can hold a common stock for over a year, it is useful to value a stock over
the investor's expected holding period. In this case, the DDM model can be used.

Formula 1.3

Sources: © 2008, N. Lavanya and T. Malarvizhi

Originally published as a part of 2008 PMI Global Congress Proceedings – Sydney, Australia
https://www.fep.up.pt/disciplinas/PGI914/Ref_topico3/ProjectRAM_APM.pdf
Colegio De San Juan De Letran
Accountancy

Example: Calculate the value of a stock with a multiple-year holdingperiod

An investor plans to hold Newco's stock for 2 years. Newco expects to pay its shareholders
common equity, \$0.25 per share over the next two years. The investor anticipates Newco's stock
will close the end of that time period at \$40 per share. Given a rate of return of 10%, what is the
value of Newco's common stock at the end of the two-year time period?

3. Infinite Period DDM

To value a common stock using the infinite period DDM, the calculation is simplified much like
it is when valuing a preferred stock with infinite dividends.

Formula 1.4

Example: Calculate the value of common stock with infinite dividends

Newco paid a \$0.25 annual dividend in 2004 and expects to pay \$0.265 in 2005. Assuming a 6%
growth rate and a required rate of return of 10%, calculate the value of Newco's stock.