Equity Markets, Valuation, and Analysis

CHAPTER 10Discounted Dividend Valuation

Elif Akben-Selçuk

Associate Professor, Gebze Technical University

INTRODUCTION

The dividend discount model (DDM), initially developed by Gordon and Shapiro (1956) and Gordon (1959, 1962), is one of the oldest and simplest models to estimate the value of a company's outstanding stock. In basic terms, the model defines the value of common stock as the present value of future dividend payments, assuming that the company has a perpetual life. Although many analysts consider the model to be outdated, it is still intuitively appealing and remains a useful tool for specific company types (Damodaran 2012; Pinto, Henry, Robinson, and Stowe 2015).

This chapter provides a detailed discussion of the DDM. It has the following organization. The next section provides a general statement of the DDM and then discusses the simplest version of the model, the constant growth or Gordon model. The following section investigates multistage models, including the two-stage model, the H-model, and the three-stage model, followed by binomial and trinomial stochastic DDMs. The chapter then examines the uses of DDMs and the results from studies testing the model's relevance. The last section summarizes and concludes the chapter.

THE GENERAL MODEL

In markets with rational investors, the value of any asset is defined as the present value of the cash flows that it is expected to provide, discounted at a rate appropriate for their risk level. In other words, investors ...