Question

In what circumstances is it most appropriate to use multistage dividend discount models rather than constant-growth models?

Answer 1

Constant-growth models: It is also called dividend discount model, this is a stock valuation method that calculates a stock’s intrinsic value, regardless of current market conditions. Investors can then compare companies against other industries using this simplified model. This values a company's stock using an assumption of constant growth in payments a company makes to its common equity shareholders. The three key inputs in the model are dividends per share, the growth rate in dividends per share, and required rate of return.

Multistage dividend discount model:  The basic concept behind the multi-stage dividend discount model is the same as constant-growth model, i.e. it bases intrinsic value on the present value of expected future cash flows of a stock. The difference is that instead of assuming a constant dividend growth rate for all periods in future, the present value calculation is broken down into different phases.is a technique used to calculate intrinsic value of a stock by identifying different growth phases of a stock; projecting dividends per share for each the periods in the high growth phase and discounting them to valuation date, finding terminal value at the start of the stable growth phase using the Gordon growth model, discounting it back to the valuation date and adding it to the present value of the high-growth phase dividends.

Multistage dividend discount model is appropriate when valuing companies with temporarily high growth rates. These companies tend to be companies in the early phases of their life cycles, when they have numerous opportunities for reinvestment, resulting in relatively rapid growth and relatively low dividends (or, in many cases, no dividends at all). As these firms mature, attractive investment opportunities are less numerous so that growth rates slow.

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