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101 Concepts for the Level I Exam

Essential Concept 48: Dividend Discount Model (DDM)


The value of a stock using DDM for a single-holding period is:

{\mathrm{V}}_0\mathrm{=}\frac{{\mathrm{D}}_{\mathrm{1}}}{{\left(\mathrm{1\ +\ r}\right)}^{\mathrm{1}}}\mathrm{+}\frac{{\mathrm{P}}_{\mathrm{1}}}{{\left(\mathrm{1\ +\ r}\right)}^{\mathrm{1}}}\mathrm{=\ }\frac{{\mathrm{D}}_{\mathrm{1}}\mathrm{\ +\ }{\mathrm{P}}_{\mathrm{1}}}{{\left(\mathrm{1\ +\ r}\right)}^{\mathrm{1}}}

 

The value of a stock using DDM for multiple finite holding periods is:

{\mathrm{V}}_0\mathrm{=\ }\sum\limits_{t=1}^{n} {\frac{{\mathrm{D}}_{\mathrm{t}}}{{\left(\mathrm{1+r}\right)}^{\mathrm{t}}}\mathrm{+}\frac{{\mathrm{P}}_{\mathrm{n}}}{{\left(\mathrm{1+r}\right)}^{\mathrm{n}}}}

 

The value of a stock for infinite holding periods is:

{\mathrm{V}}_0\mathrm{=\ }\sum\limits_{t=1}^{\alpha}{\frac{{\mathrm{D}}_{\mathrm{t}}}{{\left(\mathrm{1+r}\right)}^{\mathrm{t}}}}

 

There are two approaches to forecast dividends.

  • One is to assume that they follow a stylized growth pattern (constant growth, two-stages of growth, or three stages of growth).
  • The other alternative is to forecast dividends for a finite period, then forecast the remaining dividends based on a pattern or by calculating the terminal stock price.