MSG Team's other articles

12989 Cross Border Credit Reporting

The geographical boundaries drawn by nation states are blurring in the 21st century. In many parts of the world, free movement of goods, services, and even personnel have become a norm. However, strangely, the concept of credit and loans is still dependent upon national boundaries. The H1B visa system of America is a testimony to […]

8915 The Deutsche Bank Commerzbank Merger

Deutsche Bank which, which was once a dominant German financial institution has now become extremely fragile. This German bank managed to make it past the great recession of 2009. However, the bank has been facing one challenge after another ever since the recession got over. At the present moment, the bank is functional and solvent. […]

8846 Dealer Markets vs. Broker Markets

Markets across the world can also be segregated based on the type of intermediary. Prima facie, it may appear that the type of intermediary is not of much consequence. However, over time, market participants have realized that the type of intermediaries has a profound effect on the liquidity, efficiency as well as transaction costs related […]

11997 Why Managing Liquidity is Important for Pension Funds?

Pension funds have traditionally been viewed as long-term investors. They are an investment vehicle in which individuals invest over the course of their working lives and remove money only after the age of retirement. Hence, liquidity was not considered to be a very big problem for the pension fund industry until recently. However, in the […]

11934 Why are Professional Sports Franchises Increasing in Value?

The sports business has traditionally not been a very lucrative one. It was common for the valuation of sports franchises to stay stagnant for a large number of years or even drop down as the years progressed. However, all this has changed drastically now. It is now common for sports team franchises to drastically go […]

Search with tags

  • No tags available.

To understand the dividend discount model, we need to start from the basics. The simplest way to understand the dividend discount model and its application is to first start with a single period and then later extend it on to more complex cases. Hence, the term single period dividend discount model.

The objective of application of this model is to derive what the fair market price of the stock should be if we know certain other information about that stock. The other information is the expected future price, expected dividend payout in that single period and the investors required rate of return.

Let’s understand the application of a single period dividend discount model with the help of an example:

Example:

An investor is wondering what the correct price of a share should be? He knows that his required rate of return is 9%. He also knows that the share will give a $5 dividend in the current period and the expected market value at the end of the period is $200. What would the fair price for such a stock be?

Calculation:

We know that the value of the stock is equal to the present value of all the future cash flows that can be derived from it. In this case we are getting cash flows in two different forms. One form is dividends and the other form is the final sale proceeds.

Let’s call the dividends D1 and the final sale proceeds P1. Thus the total cash flow that we will obtain at the end of the period is D1+P1. Now the next task is to calculate the present value of these cash flows i.e. discount them at the expected rate of return for the investor.

Hence, the formula pertaining to single period dividend discount model is:

Present Market Price = (D1+P1)/(1+r)

Therefore, in our case, it equals:

($5+$200)/1.09 = $188.07

Thus, the fair market value of this stock should ideally be $188.07

Interpreting the Results:

In case the investor is fairly confident about all of his/her assumptions then the stock will provide them with a value equal to $188.07 in present value terms.

  • Hence, if the price is values at $188.07, the investor may or may not buy the stock. Since it just meets the investor’s expectations, there are no abnormal profits to be made
  • In case, the price is less than $188.07, then the stock is undervalued and the investor should immediately make the purchase. If the investor’s assumptions are correct, he/she stands to make a windfall gain from the buying and selling of this stock
  • In case, the price is greater than $188.07, then the investor should refrain from making the purchase. The stock is intrinsically worth less than what the investor would pay off for it and the investor would be better off putting that money in another investment.

Difficulty in Implementation:

The single period dividend model can tell you whether a price is overvalued or undervalued if two variables which will become known only in the future i.e. the future price and the future dividend are accurately predicted today!

Also, while theoretically investors are supposed to know their required rate of return, not many investors actually do! So the third variable being used in the formula is also slightly difficult to predict.

Needless to say, this is not a very good idea. Guessing an accurate dividend itself may be difficult. However, guessing an accurate future price is almost impossible! Therefore, it may seem like this model is not very useful and it really isn’t if you consider it on its own.

However, this model forms the building block for later models some of which are based on more realistic assumptions and are therefore much more applicable and helpful.

Article Written by

MSG Team

An insightful writer passionate about sharing expertise, trends, and tips, dedicated to inspiring and informing readers through engaging and thoughtful content.

Leave a reply

Your email address will not be published. Required fields are marked *

Related Articles

Calculating Free Cash Flows: The Case of Preferred Shares

MSG Team

Calculating Free Cash Flow to Equity

MSG Team