What it means
The basic dividend discount model says a share is worth the present value of all the dividends it will ever pay. A present value is today's worth of money received in the future, calculated by discounting at a required rate of return.
The simple version assumes a constant growth rate for ever, which does not fit a company that is expanding fast now but will mature later. The multistage version solves this by splitting the future into stages.
In the first stage, dividends are forecast year by year at a high or uneven growth rate. In the final stage, the company is assumed to grow at a stable, modest rate for ever, and a terminal value is calculated to capture all the dividends from that point on.
The terminal value is usually found with the constant growth formula, which divides the first dividend of the final stage by the required return minus the growth rate. That figure is then discounted back to today along with the earlier dividends.
Because the terminal value often makes up most of the total, small changes in the final growth rate or required return can change the answer a lot. The model is most useful for companies with a record of paying dividends and a clear growth path, such as utilities or established consumer brands.
It is less helpful for firms that pay no dividends or whose payouts are irregular. Analysts also need sensible assumptions, since the final growth rate cannot sensibly exceed the long-run growth of the wider economy.
The key nuance is that the model is only as good as its inputs. It gives a precise-looking number from imprecise forecasts, so most professionals show a range under different assumptions.
Estimating the required return and the final growth rate is the hardest part. The required return is often built from the cost of equity, which reflects the risk of the shares, and the final growth rate is usually capped at the long-run growth of the economy.
Analysts normally test a grid of values to see how much the answer moves.
In practice
Real-world examples.
Example
An analyst values a fast-growing regional bank that is raising its dividend by double digits each year. She models five years of high growth and then a steady rate in line with the economy, and compares the result with the current share price. She also checks that the dividend payout ratio implied by her forecasts stays within what the bank can afford.
Example
A utility company has a stable business but is investing heavily in new capacity. A fund manager uses a two-stage model with a few years of rising dividends followed by a steady long-term rate to decide whether to hold the shares. He checks whether the company can fund both the building programme and the dividend without borrowing too much.
Example
A finance student tests how sensitive the value is to assumptions. Lowering the long-run growth rate from 5% to 4% in the same model reduces the terminal value sharply, which shows why the final stage matters so much. She concludes that the answer should always be shown as a range rather than a single figure.
Formula
Calculation
Share value = PV of stage one dividends + PV of terminal value
Terminal value at end of stage one = Next dividend / (Required return - Long-run growth rate)
Suppose a company will pay dividends of $1.10 in year 1 and $1.21 in year 2, after which dividends grow at 5% for ever. The required return is 10%. Year 3 dividend = 1.21 x 1.05 = $1.2705, so terminal value at the end of year 2 = 1.2705 / (0.10 - 0.05) = 1.2705 / 0.05 = $25.41. Present values: 1.10 / 1.10 = $1.00, 1.21 / 1.21 = $1.00 and 25.41 / 1.21 = $21.00. Share value = 1.00 + 1.00 + 21.00 = $23.00.Case study
Seen in the real world.
Summit Consumer Brands is an illustrative, fictional company that has just started paying a dividend of $2.00 a share. Management expects the dividend to rise to $2.40 next year and $2.80 the year after, followed by steady growth of 4% for ever.
An investor with a required return of 9% calculates the year 3 dividend as 2.80 x 1.04 = $2.912. The terminal value at the end of year 2 is 2.912 / (0.09 - 0.04) = 2.912 / 0.05 = $58.24.
Discounting gives 2.40 / 1.09 = $2.20, 2.80 / 1.1881 = $2.36 and 58.24 / 1.1881 = $49.02, which together make about $53.58 a share. If the shares trade at $45, the investor sees potential value, but the illustrative lesson is that most of the value comes from the terminal stage, so the assumptions deserve scrutiny.
Watch out
Common mistakes.
- Letting the long-run growth rate exceed the required return, which makes the formula break down.
- Forgetting to discount the terminal value back to today.
- Using the model for a company that pays no dividends without adjusting the approach.
Questions
People also ask.
Why not use a single growth rate?
Because many companies grow quickly at first and then slow down, and one constant rate would misprice both phases.
How many stages should the model have?
Two or three are common, and more stages add detail but also add guesswork. Each extra stage needs its own growth rate and length, which is another assumption that could be wrong.
What is the terminal value?
It is the value at the end of the explicit forecast of all later dividends, calculated with the constant growth formula.
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