Next Day Funding – Meaning and its Benefits
In the previous article, we have already studied how commercial banks help in providing point-of-sale services to their corporate customers. We have also studied how point-of-sale systems have become strategically important for corporations. However, they are some pain points in the point-of-service system as well. Commercial banks provide another service called next-day funding in order […]
Market-Based Vs Bank-Based Financial Systems
Commercial banks do make some money by providing services such as transaction processing and payroll processing to their clients. However, to a large extent commercial banks make money by making loans to corporations. Interest income is the predominant source of income for banks around the world. Now, this puts commercial banks in direct competition with […]
Operating Cash Flow to Sales Ratio – Formula, Assumptions and Interpretation
Formula The formula for this ratio can be easily judged by its name: Operating Cash Flow to Sales Ratio = Operating Cash Flow / Sales Meaning Used Over a Period of Time: Conclusions must not be drawn based on a single number. A company may be able to convert its sales to cash for one […]
Strategic Capital Budgeting
The capital budgeting process is at the heart of the financial decision-making which takes place in any organization. However, up until now, the capital budgeting decision has been considered to be a financial decision. As a result, the evaluation of projects and the capital allocation process are based on discounted cash flow analysis. Many organizations […]
Regulatory Role Performed By the Central Bank
The two tiered system puts the central bank in control of the commercial banks. Therefore, the government authorities have delegated some of the regulatory responsibilities to the central bank. It is the job of the central bank to ensure that commercial banks are conducting their business in a manner which is considered ethical as well […]
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.
Your email address will not be published. Required fields are marked *
Calculating Free Cash Flow to the Firm: Method #2: Cash Flow From Operations
February 12, 2025
