The Dividend Discount Model

11 Pages Posted: 21 Oct 2008

See all articles by Robert S. Harris

Robert S. Harris

University of Virginia - Darden School of Business

Kenneth M. Eades

University of Virginia - Darden School of Business

Susan Chaplinsky

University of Virginia - Darden School of Business

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Abstract

This note focuses on the dividend model (DDM), or Gordon Growth Model, as it is sometimes known. The DDM appears in many forms in practice. The note examines its role in estimating the intrinsic value of an equity security and as a model for estimating the required return on equity. It also explores the DDM's link to price-earnings ratios, a widely followed market multiple, and the sustainable rate of growth.

Excerpt

UVA-F-1234

Rev. Jul. 22, 2014

THE DIVIDEND DISCOUNT MODEL

Practitioners rely on a number of different approaches to estimate the value of corporate assets. Value can be estimated using accounting, liquidation, or replacement cost data; from multiples based on comparable companies or transactions; or by discounting a stream of expected future benefits back to the present. The discounted cash flow (DCF) approach considers stock price to be the present value of future cash flows. This note focuses on the DCF approach and, in particular, the dividend discount model (DDM) or Gordon growth model (so-called because it was devised by Professor Myron Gordon in 1962). The DDM is based on the premise that the future cash flows an investor receives from a stock are cash dividends. In practice, the DDM appears in many forms. In this note, we focus on its role in estimating the intrinsic value of an equity security and as a model for estimating the required return on equity. After those concepts are established, we explore the DDM's link to price-earnings ratios, a widely followed market multiple, and to the sustainable rate of growth.

Intrinsic Value

The DDM assumes that value is a direct function of the cash flows expected in the future. In the case of a common stock, the relevant cash flows are the dividends paid plus the value of the stock when sold. The price or value of a share derived from the future stream of dividends is often referred to as the intrinsic value of the stock. Assuming that dividends are paid at the end of each year and using subscripts to denote the year of receipt, we can depict, with the following time lines and formulas, how investors can estimate a fair price for a stock they expect to hold for three years:

. . .

Keywords: cost capital equity valuation price earnings ratio intrinsic value

Suggested Citation

Harris, Robert S. and Eades, Kenneth M. and Chaplinsky, Susan J., The Dividend Discount Model. Darden Case No. UVA-F-1234, Available at SSRN: https://ssrn.com/abstract=1279272

Robert S. Harris (Contact Author)

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4823 (Phone)
434-924-4859 (Fax)

HOME PAGE: http://www.darden.virginia.edu/faculty/harris.htm

Kenneth M. Eades

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4825 (Phone)
434-924-0714 (Fax)

HOME PAGE: http://www.darden.virginia.edu/faculty/eades.htm

Susan J. Chaplinsky

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4810 (Phone)
434-243-7676 (Fax)

HOME PAGE: http://www.darden.virginia.edu/faculty/chaplinsky.htm

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