In the previous two articles, we saw how information regarding the possible future price, dividends and rate of return expected by the investor can be used to derive the present value of an equity security. However, these models were limited in their scope.

1. Firstly, they had limited horizon periods viz. one period and two periods.

2. Secondly, they required an estimate of the future stock price which is almost impossible to predict.

In this article, we will use the former two models to come up with the generic dividend discount model. This model can value equity securities given the infinite and perpetual life that they have. Also, it does not require an estimate of the selling price. Instead the estimate of the selling price is replaced by the concept of terminal value. Let’s have a look at these concepts in greater detail in this article.

The concept of terminal value

The generic dividend discount model disregards the idea of selling price and the resulting capital gain as being a part of the valuation of any given stock. The logic behind this is that if A sells his stock to B, then the buying price that B will pay to A will also be in anticipation of future dividends.

Thus, there is no selling price or P1 as we have considered in the previous articles. P1 is the price received by A, if you think from the point of view of A. Rather we have to think in terms of the security itself. The intrinsic value of the security is not driven by the selling price. There is no reason why selling price should even exist!

The selling price is thus nothing more than the discounted present value of future dividends that B is paying to A to collect the dividends himself later. Thus, it can be said that the value of a stock is derived only and only on the basis of the dividends that it pays out through its lifetime. The value of a stock is therefore the value of a perpetual stream of dividends that are expected to be received.

This makes things easier from a practical point of view as well. Dividends that will be paid out by the firm are relatively easier to predict. Hence, the valuation can be more accurate. Instead if we use expected future price of a stock to be a factor in valuing the stock, we are stuck into a circular loop. Any valuation becomes purely a judgment call.

The Formula

The valuation of a stock can therefore simply be reduced to being the present value of all future dividends that will be received by the company.

Thus, if the company is going to live for “n” years, then the value of this stock will be:

This is the gist of the dividend discount model. The earlier two articles proved the fact that a stock could be valued if it’s selling price and dividends were known. This article proves that selling price itself is nothing but the present value of dividends. Hence, the value of any stock, according to this model depends upon the future stream of dividends that can be derived from it.

Horizon Period and Terminal Value

For the purpose of valuation, the calculation is broken down into two parts. One part is called the horizon period. The analyst can choose the length of the horizon period as per his/her liking. Analysts usually choose 5 to 7 years as the horizon period. For the horizon period, the dividends are explicitly projected and discounted to reach the value.

On the other hand, the rest of the stocks dividends are valued as perpetuity. This perpetuity is called the terminal value. The value of the stock is thus composed of the value of the horizon period as well as the terminal value.

The dividend discount model is one of the oldest models for stock valuation. All other models are derivations or offshoots of this fundamental model.