Copyright © Kit Pasula 2021.

Not to be copied or distributed in any way.

Topic: Valuation Using the

Dividend Discount Model (DDM)

(can start and stop recording)

 1. Introduction

Valuation of stock prices over a longer time period

DDM based on the EMT
At start, analysis is based on the ‘efficient market theory’ (EMT). In the
EMT, stocks are always properly valued in equilibrium (based on
information available today).
DDM based on an investor’s view
At end of topic, assume an investor has a different view than ‘the
market’. The investor’s own ‘fair stock price’ is derived to see if the
stock is overvalued or undervalued based on the investor’s view.
 Can apply DDM to stocks in general or to
individual stocks
Can apply to a stock market index (bundle of stocks)
or to individual stocks.

Later on, when considering case of an investor looking for over/under

valued stocks, will look at examples based on individual stocks
(the success of the technique will depend on, among other things, the
quality of the underlying predictions of the investor).
 2. Expected Return on the Stock and the
New Meaning of the Subscript t
𝑠𝑒 𝑒
𝑃𝑡+1 − 𝑃𝑡𝑠 𝐷𝑡+1
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑠𝑡𝑜𝑐𝑘 = 𝑠 +
𝑃𝑡 𝑃𝑡𝑠

1. Explain components of expected return.

2. In this framework, subscript t refers to period t (not time t). Period t
is like a year, such as this year. The DDM model is used for longer-term
analysis.
 Equilibrium Condition in the EMT

𝑖𝑡 + 𝜑𝑡 = κ

κ
In the EMT, the Greek letter kappa is the equilibrium expected
return on the stock (in the topic at the end, thought of as the ‘fair
rate of return’).

In the analysis, will hold κ fixed; in period t, it is given.

But later on, can think of κ changing when, for example, the
interest rate changes as one moves through time.
3. The Derivation (of the fair stock price in the EMT)
Valuing the Asset
𝑒 𝑒
𝐷𝑡+1 𝑃𝑡+1 − 𝑃𝑡𝑠
κ = 𝑠 +
𝑃𝑡 𝑃𝑡𝑠

This equation can be rearranged to

𝑒 𝑠𝑒
𝑠
𝐷𝑡+1 𝑃𝑡+1
𝑃𝑡 = +
1+κ 1+κ

Explain the meaning (present value …)

 Take expectations as of period t and substitute in
𝑒 𝑠𝑒
𝐷𝑡+1 𝑃𝑡+1
𝑃𝑡𝑠 = +
1+κ 1+κ

𝑒
𝐷𝑡+2 𝑠𝑒
𝑃𝑡+2 𝑒
𝐷𝑡+3 𝑠𝑒
𝑃𝑡+3
𝑠 𝑠
𝑃𝑡+1 = + and 𝑃𝑡+2 = +
1+κ 1+κ 1+κ 1+κ

𝑒 𝑠𝑒
𝐷 𝑡+2 𝑃 𝑡+2
𝐷 𝑒 + 𝐷 𝑒
𝐷 𝑒
𝑃 𝑠𝑒
𝑠
𝑃𝑡 =
𝑡+1
+ 1 + κ 1 + κ =
𝑡+1
+
𝑡+2
+
𝑡+2
,
1+κ 1+κ (1 + κ) (1 + κ) 2 (1 + κ) 2

𝑒 𝑒 𝑒 𝑠𝑒
𝑠
𝐷 𝑡+1 𝐷𝑡+2 𝐷𝑡+3 𝑃𝑡+3
𝑃𝑡 = + 2
+ 3
+
(1 + κ) (1 + κ) (1 + κ) (1 + κ)3
 Keep Repeating
𝑒 𝑒 𝑒 𝑠𝑒
𝑠
𝐷 𝑡+1 𝐷𝑡+2 𝐷𝑡+3 𝑃𝑡+3
𝑃𝑡 = + 2
+ 3
+
(1 + κ) (1 + κ) (1 + κ) (1 + κ)3

Explain, in words, why this equation makes sense.

𝑒 𝑒 𝑒 𝑒 𝑒
𝐷𝑡+1 𝐷𝑡+2 𝐷𝑡+3 𝐷𝑡+4 𝐷𝑡+5
𝑃𝑡𝑠 = + + + + + …
(1+κ) (1+κ)2 (1+κ)3 (1+κ)4 (1+κ)5

The ‘dividend discount model’

All the different Pst equations give same answer.
Given assumptions, one can solve this infinite sum.
 4. Case 1: D expected to stay constant forever (g = 0%)

we know Dt (it is paid at start of period; or, in real world, represents

dividends in the past year)
Assume D grows at constant rate g = 0%
Dt+j = Dt for all j = 1, 2, 3, …

𝑒
𝑠
𝐷𝑡+1 𝐷𝑡
𝑃𝑡 = =
κ κ
If dividend is 10 and k is 0.10, what is fair stock price?
5. Case 2: D expected to grow at constant rate g forever (g < k)
Know Dt
𝑒
𝐷𝑡+1 = (1+g) 𝐷𝑡
𝑒 𝑒
𝐷𝑡+2 = (1+g) 𝐷𝑡+1 = (1+g) (1+g) 𝐷𝑡 = what?
𝑒
𝐷𝑡+2 =
And so on.
𝑒
𝐷𝑡+1
𝑃𝑡𝑠 =
κ−𝑔
If current dividend is 10, k is 20% and g = 10%, what is fair stock price?
need g < k (but that is logical)
 a note (use numbers too)

𝑒
𝑠
𝐷𝑡+1
𝑃𝑡 =
κ−𝑔

(calculate price in t and note what t+1 price should be)

Rewrite above

𝑒
𝐷𝑡+1
κ= +𝑔
𝑃𝑡𝑠

Dividends grow at rate g, and …

 Copyright © Kit Pasula 2021.
Not to be copied or distributed in any way.

Topic: Valuation Using the

Dividend Discount Model (DDM)

(can start and stop recording)

 6. Case 3: More General Case
D grows at non-constant rate for the first few years, but at some point
it begins growing at constant rate g forever into the future.
Some examples in time diagrams
Example
7. Some Exogenous Changes (using Case 2)

𝑒
𝑠
𝐷𝑡+1
𝑃𝑡 =
κ−𝑔

Exogenous changes (previously unexpected)

(explain effects on current stock price)
1. one-time increase in D, holding g constant (news)
2. One-time decrease in the interest rate
 8. Valuation for An Investor with
View different than ‘the market’
Is a stock overvalued or undervalued, given the predictions of this
investor?
Process
Write down the predictions.
Calculate the fair stock price (based on assumed ‘fair rate of return’).
Compare it to the actual stock price.
Based on calculations, is stock properly valued, overvalued, or
undervalued?
Do predictions seem reasonable? If so, …
 comments
May be many times when Case 2 not valid (recession, unusual events for the
company, and so on). Also, is the current D representative?
Can one assume that g is contant starting from right now? Or is it more
appropriate to incorporate the prediction that g becomes constant in a
future period?

Note: even though we know g will not be perfectly constant in future, it is ok

to use the assumption that it will be constant at that level (with fluctuations
that tend to cancel out).
As noted at the outset, approach more successful the better the predictions
of the investor. And need to be long-term investor: this investor may predict
better, but stock price will only reflect that when others figure it out too.
Example 1
Example 2
 9. Other Comments
What if a company never pays dividends?

Consider a bank (for example): comment on growth in D and E

and growth in nominal GDP
 Many other interesting topics,
so let’s move on to the next topic.