Dividend Discount Model:

[Constant Growth Model / Zero Growth Model / Two-stage Model /

‘H’ Model / Three –stage Model.]

What is the 'Gordon Growth Model'

The Gordon growth model is used to determine the intrinsic

value of a stock based on a future series of dividends that grow at
a constant rate. Given a dividend per share that is payable in one
year, and the assumption the dividend grows at a constant rate
in perpetuity, the model solves for the present value of the infinite
series of future dividends.

Where:

D = Expected dividend per share one year from now

k = Required rate of return for equity investor

G = Growth rate in dividends (in perpetuity)

Because the model simplistically assumes a constant growth rate,

it is generally only used for companies with stable growth rates in
dividends per share.

Limitations of the Gordon Growth Model

The main limitation of the Gordon growth model lies in its

assumption of a constant growth in dividends per share. It is very
rare for companies to show constant growth in their dividends due
to business cycles and unexpected financial difficulties or
successes. Therefore, the model is limited to firms showing stable
growth rates. The second issue has to do with the relationship
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between the discount factor and the growth rate used in the
model. If the required rate of return is less than the growth rate of
dividends per share, the result is a negative value, rendering the
model worthless. Also, if the required rate of return is the
same as the growth rate, the value per share approaches
infinity.

Constant Growth Model ( DDM):

The dividend discount model (DDM) is a method of valuing a
company's stock price based on the theory that its stock is worth
the sum of all of its future dividend payments, discounted
back to their present value. ... is the constant growth rate in
perpetuity expected for the dividends.

Zero Growth Model:

The formula for the present value of a stock with zero growth
is dividends per period divided by the required return per
period. The present value of stock formulas are not to be
considered an exact or guaranteed approach to valuing a
stock but is a more theoretical approach.

The present value of a stock formula used above is specific to

stocks that have zero growth, or no growth. It is important to
remember that the period used for both dividends and the
required return must match. For example, if one is using
annual dividends, then the annual return must be used.

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Two – stage Model:
In the two-stage model, it is assumed that the first stage
goes through an extraordinary growth phase while the
second stage goes through a constant growth phase.
In H model, the growth rate in the first phase is not constant but
reduces gradually to approach the constant growth rate in the
second stage. The key point to note here is that the growth rate is
assumed to reduce in a linear way in the initial phase till it
reaches stable growth rate in the second stage. The model also
makes an assumption that dividend payout and cost of equity
remain constant. Let us take an example illustrating firm value
using H model dividend discount model.

What Is the H-Model?

The H-Model dividend discount formula is like the two-stage
model in that it calculates the present value of dividends in
two key phases. However, whereas the two-stage model
assumes dividends will grow at one rate and then suddenly drop
to a lower rate for the foreseeable future, the H-Model accounts
for the gradual change in dividend rates over time.
In the first phase of the H-Model calculation, dividends are
assumed to increase or decrease in regular increments each

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year. For example, a company’s dividend growth rate may decline
by 2% each year for three years to transition from 15% to 9%.
The rate of change remains consistent but the growth rate itself
gradually decreases.
The second stage of the H-Model is identical to that of the two-
stage model or the Gordon Growth Model. During the first phase,
the growth rate slowly changes until it stabilizes at the growth rate
that will be maintained over the life of the company. In the
example above, the fourth year would see dividend growth
reduced to 7%, where it would stabilize. The Gordon Growth
Model formula can be used to calculate the present value of all
future dividends based on this stable 7% increase per year.

Like the two-stage, three-stage, and Gordon Growth models, the

H-Model is a valuation formula that discounts future cash flows
using an expected rate of return to account for the time value of
money. A dollar earned a year from now is worth less than a
dollar earned today because funds you have today can be
invested to generate interest over the coming year, while money
you have to wait for cannot. The time value of money, therefore,
means that each subsequent dividend dollar is worth less today
than the one before it because you have to wait longer to receive
it.

Because dividend discount models are predictive by nature, they

use the required rate of return or cost of equity to discount future
dividend payments and render the present value of a stock after
accounting for the time value of money.

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The H Dividend Discount Model Formula
As a dividend discount valuation formula becomes more precise,
it also becomes more complex. However, the basic components
of this formula remain simple to understand and easy to
assemble. All that is needed are the initial growth rate, the final
rate at which dividend growth will stabilize after transitioning from
the current rate, the period over which the rate will change, the
expected rate of return, and the amount of the dividend payment
to be paid one year from today.

In this formula, D0 is the current year’s dividend payment, g1 and

g2 are the initial and terminal growth rates, respectively, r is the
expected rate of return and H is equal to half of the anticipated
transition period.

THREE – STAGE MODEL:

Some of the limitations can be handled by the use of 3 stage
model. A 3 stage model assumes 1st stage to have an extra-
ordinary high rate of growth, the second stage having a
reducing growth rate and the third stage having a constant
stable growth rate. One can say that it is a blend of two stage
model and H model.
In cases where the transition happens faster from extraordinary
phase to stable growth rate phase, a three-stage model may
behave same as in the same way as H model and so would the

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 value of the firm using either model. As a result, a good number of
cases for H model yield similar results as the three stages model.

Dividend Payouts vs. Share Repurchases

For income investors, share repurchases offer very little benefit.

Dividends, on the other hand, entice long-term investment in the
company. In this scenario, the company benefits from a stable
shareholder base while investors capitalize on a more profitable
portfolio.
Below is a summary of key reasons why dividend payouts are
more effective from an investor’s perspective:

 Flexibility: Whereas share repurchases offer flexibility for the

corporation, dividend payouts give investors the option of
expanding their holdings or reinvesting earnings into the
company.

 Readily Available Cash: Flexibility extends far beyond

reinvestment potential. Under a dividend payout structure,
investors can collect cold hard cash.

 Shareholder Return: When a company pays dividends, all

shareholders get paid out. This isn’t the case for buybacks, which
are self-selected. This means that only those shareholders who
tender their shares back to the company receive cash.

 Management Discipline: Under a dividend payout scheme,

corporations are prevented from retaining too much cash. Having
too much cash on hand often results in foolish ventures or poorly
thought-out acquisitions. Dividend payouts instead focus on
keeping shareholders happy.

 Share Count: When a company pays a dividend, the overall

share count is unaffected. This isn’t the case in a repurchase,

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where the overall share count declines by the number of shares
bought back.

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