Question

Explain the different types of dividend growth and how to find the value for each type.

Answer 1

1. Dividend discount model(DDM): It is used to calculate the value of a stock by discounting the sum of all the future dividends paid by the company. It assumes that the current value of the stock would be equal to the present value of all the future dividends.  

Value of a stock = D1/(1+r) + D2/(1+r)^2 ---------------------------+ Dn/(1+r)^n

Di = The most recent dividend payment

r = rate of return

2. Gordon growth model or Constant growth rate model: It assumes that the dividend grows at a constant growth rate, therefore discounting the future series of the dividend that grows at a constant rate in perpetuity to determine the intrinsic value of the stock.

Value of a stock = D0(1+g) / (r - g) where r > g

3. The two-stage dividend growth model: In this model, the dividend will go through two stages. In the first stage, the dividend will grow at a constant rate for a certain period of time and then grow at a different rate in perpetuity for the remaining period of the company's life.

Value of a stock = D0 (1+g1)/(1+r) + D0 (1+g1)^2/(1+r)^2 + ---- +D0(1+g1)^n/(1+r)^n + (Dn(1+g2)/ (r-g2)) /(1+r)^n

For n periods: dividend grow at a rate of g1

After n periods and till perpetuity: dividend grow at a rate of g2

4. H - model: H-model is just like the two-stage model but assumes that growth starts at a higher rate and gradually decreasing over time and at last achieves a stable growth rate.

P0 = D0(1+g2)/r-g2 + D0*H*(g1-g2) / (r - g2)

• D0 = The most recent dividend payment
• g1 = The initial high growth rate
• g2 = The terminal growth rate
• r = The discount rate
• H = The half-life of the high growth period