Encyclopedia of Financial Models II

Dividend Discount Models

PAMELA P. DRAKE, PhD, CFA

J. Gray Ferguson Professor of Finance, College of Business, James Madison University

FRANK J. FABOZZI, PhD, CFA, CPA

Professor of Finance, EDHEC Business School

Abstract: Dividends are cash payments made by a corporation to its owners. Though cash dividends are paid to both preferred and common shareholders, most of the focus of the attention is on the dividends paid to the residual owners of the corporation, the common shareholders. Dividends paid to common and preferred shareholders are not legal obligations of a corporation, and some corporations do not pay cash dividends. But for those companies that pay dividends, changes in dividends are noticed by investors—increases in dividends are viewed favorably and are associated with increases in the company's stock price, whereas decreases in dividends are viewed quite unfavorably and are associated with decreases in the company's stock price. Most models that use dividends in the estimation of stock value use current dividends, some measure of historical or projected dividend growth, and an estimate of the required rate of return. Popular models include the basic dividend discount model that assumes a constant dividend growth, and the multiple-phase models, which include the two-stage dividend growth model and the stochastic dividend discount models.

In this entry, we discuss dividend discount models and their limitations. We begin with a review of the various ways to measure ...