Damodaran on Valuation

5.1. DIVIDEND DISCOUNT MODELS

The oldest discounted cash flow models in practice are dividend discount models. While many analysts have turned away from dividend discount models on the premise that they yield estimates of value that are far too conservative, several of the fundamental principles that come through with dividend discount models apply when we we look at other discounted cash flow models.

5.1.1. Underlying Principle

When investors buy stock in publicly traded companies, they generally expect to get two types of cash flows: dividends during the holding period and an expected price at the end of the holding period. Since this expected price is itself determined by future dividends, the value of a stock can be written as the present value of dividends in perpetuity.

The rationale for the model lies in the present value rule: The value of any asset is the present value (PV) of expected future cash flows discounted at a rate appropriate to the riskiness of the cash flows.

There are two basic inputs to the model: expected dividends and the cost of equity. To obtain the expected dividends, we make assumptions about expected future growth rates in earnings and payout ratios. The required rate of return on a stock is determined by its riskiness, measured differently in different models—the market beta in the capital asset pricing model (CAPM), and the factor betas in the ...