Risks in Money Market Investing
Money market instruments are considered to be very low-risk investments. This is because the money market as an asset class is considered to have a considerably low-risk profile as compared to other asset classes such as equity and debt. The main reason for the low-risk profile is because money market instruments consist of a large […]
The Anatomy of Commodity Indices
Movements in the stock markets are easy to track. This is because instead of looking at the movements in the price of several different stocks, investors can simply look at the movement in the underlying index. This is where the concept of index is derived from. It provides a pulse of the market wherein one […]
Problems with Bank Term Funding Program (BTFP)
The Silicon Valley Bank crisis has prompted the Federal Reserve to evaluate its emergency funding program. The original emergency funding program i.e. the discount window was obviously not sufficient to provide funding to failing banks such as the Silicon Valley Bank. This is the reason that the bank ended up failing. The Fed felt the […]
Over the Counter Markets
Over the counter markets are a particular type of financial market. Generally, financial markets are centralized. This means that there is one central body that is a counterparty to all the trades being made. For instance, if A wants to trade with B, the transaction does not happen directly. Instead, A trades with the centralized […]
Margin Mechanism in Exchange Traded Derivatives
When it comes to exchange traded derivatives, one of the first things that need to be understood is the margin mechanism. Since most people that use exchange traded derivatives also use leverage, this is the procedure that they have to follow. The process may seem to be complicated. However, it is one of the wonders […]
The next step towards understanding the dividend discount model is to extend the conclusions derived from the single step dividend model. This brings us to the two period dividend discount model. In this model we will use the same logic. However, we will extend the assumption regarding the holding period. Instead of selling his stock at the end of period 1, the investor holds on to the stock and only sells it at the end of period two. The question arises, how the investor should value the stock this time.
Once again, we will understand this with the help of an example:
An investor is confident that a certain stock can be sold off for $100 if it is held on to for 2 years. He has a required rate of return of 10%.He is also confident that the company will pay a $4 dividend in the first year and a $6 dividend in the second year. However, he is not certain about what the price of the stock should be today?
Calculation:
Once again, the value of the stock is only equal to the present value of all future cash flows that can be derived from that stock. In this case, we will receive three different cash flows.
Also, note that the first cash flow will be received at the end of year 1. However, the second and third cash flows will be simultaneously received at the end of year 2.
Hence, we will discount the first dividend of $4 at 10% for 1 period only. However, second dividend plus the final sale proceeds i.e. $6 and $100 are to be received after two years, therefore they will be discounted for 2 periods.
The formula for the two period dividend discount model is:
= [D1/(1+r)]+ [D2+P2/(1+r)2 ]
= [$4/(1.1)]+ [$6+$100/(1.1)2 ]
= $3.7 + $87.6
=$91.3
Thus, from the given assumptions the value of this investment should be equal to $91.3 in present value terms
Once again,
This model too cannot be used on its own for very accurate results. Once again the reason is that it uses hard to predict variables like future price and future dividends as inputs. However, the two step dividend discount model is proof that the concept of discounting dividends can be extended to several years.
This proof will be used in the next article, to finally arrive at the generic dividend discount model. The assumptions in the generic model are comparably more realistic which makes it usable. In fact it is amongst the most preferred equity valuation models used by cautious investors.
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Calculating Free Cash Flow to the Firm: Method #2: Cash Flow From Operations
February 12, 2025
