Multiple Period Model of Equity Valuation – Dividend Discount Model

Multiple Period Model of Equity Valuation- dividend discount model, like any other discounted cash flow model, aims at arriving at the intrinsic/fair value of the stock. In the multi-period model, we take into account the dividend stream for infinite years and discount it using appropriate discount rate to arrive at the fair value; however assuming the investor has a holding period in mind, the multi-period model will take that many years into account to arrive the intrinsic value of the stock.

In essence, the price can be calculated as follows:

How to Calculate Stock Price Using Multi-Period Dividend Discount Model Formula?

Formula

Po = D1/ (1+r) + D2/ (1+r) ^2 + D3/ (1+r) ^3 + …… Dn/ (1+r) ^n

Where,

Po = Price of the equity share

D1 = expected dividend 1 year from now

D2 = expected dividend 2 years from now

Dn = expected dividend n years from now

r = expected rate of return (cost of equity)

This formula takes into account an infinite number of years, which in a real world situation is difficult to forecast, and one may use perpetuity as a dividend value after few years beyond which forecast is difficult. For shorter holding periods, one can use the multi-period to value the stock price as listed in the below example.

Example of Multi-Period Model – Dividend Discount Model

Let us look at an example where a particular investor with a 5-year horizon wants to calculate the fair value of the stock.  Given the expected dividend stream for next 5 years and expected price after 5 years, one can arrive at the intrinsic value of the stock using an appropriate discount rate. The following information is available:

D1 = $ 2, D2 = $ 3, D3 = $ 4, D4 = $ 5, D5 = $ 6

Expected stock price after 5yrs = $ 120

Cost of equity (required rate of return) = 10%

Using the information available, the value of the stock can be calculated as follows:

Tenor Cash Flow Discount Rate Present Value
1 $ 2 10% 2 / (1+10%)^1 = 1.82
2 $ 3 10% 3 / (1+10%)^2 = 2.48
3 $ 4 10% 4 / (1+10%)^3 = 3.00
4 $ 5 10% 5 / (1+10%)^4 = 3.42
5 $ 6 10% 6 / (1+10%)^5 = 3.72
5 $ 120 10% 120 / (1+10%)^5 = 74.51

The intrinsic value of the stock will be a summation of all present values and in our case, this sums up to $ 88.95.

Interpretation for Multi Period Model

The fair price arrived using the multi-period model can be used by investors to make investment decisions in the stock market. If the market price is lower than the value calculated using this model, one can look to buy the stock as the stock is trading undervalued and vice versa when a stock is trading higher than the value calculated using the model. However, if the market prices seem fair one may need to revisit the estimates of the stock price at the end of the holding period, the dividend estimations and the cost of equity.  To estimate intrinsic value closer to reality one needs to assume infinite periods and hence one may look at the other multi-period dividend discount models like two-stage growth model, H model or three stage growth model which will help the investor to reduce the error in estimation of fair/intrinsic value.

References:

http://www.psnacet.edu.in/courses/MBA/sapm/lecture-20.pdf

http://www.subjectmoney.com/definitiondisplay.php?word=Dividend%20Discount%20Model%20(Stock%20Valuation)

http://educ.jmu.edu/~drakepp/FIN362/resources/dvm.pdf

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