Dividend Discount Method

The Dividend Discount Model calculates the value of the equity of a firm directly from the expected cash flows received by the shareholders—the Dividends. These flows are discounted at the cost of equity. The advantage of this method is that it enables you to compute Shareholder Value directly from the flows that the shareholders are actually forecast to receive.

Dividend Discount Model has disadvantages:

  • If a firm adopts a fixed dividend policy, that firm's leverage may drift from the target leverage. If a firm is accumulating and investing cash in the form of marketable securities, leverage falls as does the Cost of Equity used to discount the dividend flows. If a firm is taking on debt to maintain its dividend policy, leverage and the Cost of Equity rise. Because the Cost of Equity is sensitive to changes in leverage, it needs to be adjusted for these changes in leverage to produce an accurate valuation.

  • If a firm is accumulating cash or debt, sooner or later it needs to adjust the flows to shareholders to account for this. Strategic Finance assumes that, if such an adjustment is required, it can be done at the end of the forecast period.

  • If a firm is accumulating cash, it is de-levering and its Cost of Equity is being reduced. Consider the firm as engaging in two businesses: the normal business of the firm, and the business of investment (which you would expect to be less risky than the normal business of the firm).

If a firm adjusts its dividend policy to maintain a constant leverage, it is paying what Strategic Finance refers to as the “Affordable Dividend.” This eliminates the problems with changes in leverage, but few firms are expected to pay their Affordable Dividend in each year. Thus, you would no longer be forecasting the expected real flows to shareholders.

See Mid-Period versus End-of-Period Discounting