- Dividend discount model
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The dividend discount model is a way of valuing a company based on the theory that a stock is worth the discounted sum of all of its future dividend payments.[1] In other words, it is used to evaluate stocks based on the net present value of the future dividends. [2]Dividend discount model is a tool that produces a number based on the data provided. The equation can be written as
where P0 is the current stock price, D1 is the expected dividend, r is the required rate of return, and g is the expected growth rate in perpetuity.
This equation is also used to estimate cost of capital by solving for r
From the first equation, one might notice that in the long run, the growth rate cannot exceed the cost of equity; r − g cannot be negative, i.e., r > g. In the short run if g > r, then usually a two stage DDM is used:Therefore,
where g denotes the short-run expected growth rate,
denotes the long-run growth rate, and N is the period (number of years), over which the short-run growth rate is applied.
See also
References
Categories:- Economics and finance stubs
- Financial terminology
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