Question

Formally derive and discuss the dividend discount model used for the valuation of common stocks

Answer 1

Dividend discount model believes that the share price of the company should be reflecting the dividend payments of the company which are related to the future and which is to be discounted at the present value.

Dividend discount model believes that share price of the company should be representation of the intrinsic value of the company which has been calculated after discounting of the cash flows which will be yielding from payment of dividend from the company because these dividends are straight representing the profits which are made by the business in the long run so they need to be derived at the present value through discounting at an appropriate rate in order to arrived at the fair intrinsic value of this year.

these dividend discount model can assign a growth on the dividend or it also feels that dividend can be constant.

When the dividend is constant=( D1/ke)

it is used to divide the required dividend payment by required rate of return in order to arrive at the fair value of the share.

When it feels that there is a growth and that growth is constant in nature-

P0= D1/(ke-g)

it will be discounting the dividend payment with required rate of return which is to be deducted by the growth of the dividend payment so it will be presenting with the lower rate of discounting and it will be helping in generating a higher intrinsic value.