The projected cash flows in a DDM – the dividends anticipated to be issued – must be discounted back to the date of the valuation to account for the “time value of money”. Learn More → Hedge Fund Primer Cost of Equity in Dividend Discount Model (DDM) Upon completion, the DDM directly calculates the equity value (and implied share price) similar to levered DCFs, whereas unlevered DCFs calculate the enterprise value directly – and would require further adjustments to get to equity value. And for the terminal value calculation, the exit multiple used can be either an equity value-based multiple or enterprise value-based multiple – depending on whether the DCF is on a levered or unlevered basis.P/E) must be used if the exit multiple approach is used. For calculating the terminal value, an equity value-based multiple (e.g.The DCF, on the other hand, projects a company’s future free cash flows (FCFs) based on discretionary operating assumptions such as profitability margins, revenue growth rate, free cash flow conversion ratio, and more.The DDM forecasts a company’s future dividend payments based on specific dividend per share (DPS) and growth rate assumptions, which are discounted using the cost of equity.While the DDM methodology is relied upon less by equity analysts and many nowadays view it as an outdated approach, there are several similarities between the DDM and DCF valuation methodologies. The dividend discount model (DDM) states that a company is worth the sum of the present value (PV) of all its future dividends, whereas the discounted cash flow model (DCF) states that a company is worth the sum of its discounted future free cash flows (FCFs). Three-Stage DDM: An extension of the two-stage DDM, the three-stage variation consists of three stages, with the dividend growth rate declining over time.ĭDM vs.Two-Stage DDM: Considered a “multi-stage” DDM, the two-stage DDM determines the value of a company’s share price with the model split between an initial forecast period of increased dividend growth and then a period of stable dividend growth.Gordon Growth DDM: Frequently called the constant growth DDM, as implied by the name, the Gordon Growth variation attaches a perpetual dividend growth rate with no change throughout the entirety of the forecast.Zero Growth: The simplest variation of the dividend discount model assumes the growth rate of the dividend remains constant into perpetuity, and the share price is equal to the annualized dividend divided by the discount rate.In effect, the estimated share price accounts for how companies adjust their dividend payout policy as they mature and reach the later stages of the forecast.įor instance, unlike the Gordon Growth Model – which assumes a fixed perpetual growth rate – the two-stage DDM variation assumes the company’s dividend growth rate will remain constant for some time.Īt some point, the growth rate is then decreased as the growth assumption used in the first stage is unsustainable in the long term. Constant Growth Stage: Lower, Sustainable Dividend Growth Rates.Initial Growth Stage: Higher, Unsustainable Dividend Growth Rates.Multi-stage dividend discount models tend to be more complicated than the simpler Gordon Growth Model, because, at the bare minimum, the model is broken into 2 separate parts: an unchanged policy with a stable track record), the fewer stages the model will be comprised of.īut if dividend issuances have been fluctuating, the model must be broken into separate parts to account for the unstable growth. There are several variations of the dividend discount model (DDM) with the maturity and historical payout of dividends determining which appropriate variation should be used.Īs a general rule, the more mature the company and the more predictable the dividend growth rate (i.e. Under the strictest criterion, the only real “cash flows” received by shareholders are dividend payments – hence, using dividend payments and the growth of said payments are the primary factors in the DDM approach. Under the dividend discount model (DDM), the value per share of a company is equal to the sum of the present value of all expected dividends to be issued to shareholders.Īlthough a subjective determination, valid claims could be made that the free cash flow calculation is prone to manipulation through misleading adjustments. The Dividend Discount Model (DDM) states that the intrinsic value of a company is a function of the sum of all the expected dividends, with each payment discounted to the present date.Ĭonsidered to be an intrinsic valuation method, the unique assumption specific to the DDM approach is the treatment of dividends as the cash flows of a company.
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