Dividend Discount Model

S

spartanag07

New member
Joined
Jul 15, 2007
Messages
0
Reaction score
0
I know that the Dividend Discount Model for an infinite period is as follows:

D1/(k-g)

I was wondering if someone can explain the logic of this. Why are we subtracting g from k? Don't we want to discount it at the required rate of return?
 
spartanag07, it may help to consider the single-stage DDM in contrast to a perpetuity.

In the case of a perpetuity, the cash flow remains level and is paid over the same interval forever. Its present value is as follows:

PV = CF / k

Think of a perpetuity as a dividend that doesn't grow.

PV = CF_0 * (1 + g) / (k - g)

Note that g = 0 and this results in the same PV as the first equation.

A cash flow that's growing at a constant rate, forever, has a higher PV than a level payment. The growth rate decreases the required rate of return.

If the growth rate isn't constant, you'll need a multi-stage DDM. You'll be seeing a lot of this again at Level II with the free-cash-flow discount models and H-Model.



Edited 1 time(s). Last edit at Sunday, August 5, 2007 at 03:13PM by hiredguns1.
 
You must log in or register to reply here.
Back
Top