Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

DDM

The DDM is intellectually and ideally the best model for valuing companies. The generalized formula is next year’s dividend divided by some discount rate that is appropriate for that year, plus the second year’s dividend divided by some discount rate that is appropriate for that year, and so on. The generalized model requires the analyst to estimate a dividend for every year from now to eternity as well as the appropriate discount rate, which may be different from year to year because inflation, the expected return on alternative investments, and the risk of the company and of the market itself may all be different from year to year. For the constant-growth version, the DDM states that a company’s stock price is equal to the next year’s dividend divided by the difference between k, the required rate of return, and g, the expected dividend growth rate in perpetuity. The DDM also comes in multistage models, which can vary from 2-stage models to 102-stage models. Multistage DDMs usually have a supernormal period in which earnings growth or dividend growth is higher than the long-term average for a mature company. Then they have a normalization period, during which the dividend growth rate reverts to some long-term sustainable level, and finally, a mature period, in which the dividend growth rate is constant.

An advantage of any DDM approach is that all of the input assumptions can be as explicit, complicated, and specific as the analyst desires. Building such a model forces the ...