Dividend Discount Model

In this process the dividend in the future is predicted and its current value is determined, using this dividend value the price of the equity is determined.  The investor uses this method to identify whether the stock is trading at a premium or discount. If the stock is trading at a discount then the traders will purchase it. If the stock trades at a premium then the traders will sell their stocks. It is calculated using the formula

Dividend Discounted value of the stock= Dividend given per share/Discount rate-Dividend growth rate.

The main draw back in this method is that it does not work for companies that do not give dividend. The cost of capital can also be calculated by this method. Dividend discount model uses the future cash flow expected to determine the stock price.

The dividend discount model uses three models they are,

• Zero growth model is a model in which the dividend is assumed to be equal through out the entire analyzing period. There is no increase or decrease in dividend paid and hence there is no growth hence it is called as Zero growth model.  
• The constant growth model is a one in which there is constant increase in the dividend paid at a particular percentage. The dividend keeps on increasing at a particular percentage annually.
• The final model is Variable-growth model in which there are three phases which are   a) faster initial stage is a stage in which the dividend given increases drastically every year. The company usually gives a higher dividend in order to create a demand for its stock in the market.  b)  Slower transition stage is a stage in which the company tries to consolidate in its growth. It will try to stabilize in this stage. The dividend given in this stage will become stable. c) Lower growth final stage  is the last phase of the company when it is about to wind up its operation due to various reason.

Dividend discount model is one of the model that is being widely used these days for determining the share price and there by to make investments decision.

Question

• What are the various models in dividend discount model?
• List the situation in which this model is ineffective?