Terminal value in a two-stage DDM

The value at year $N$ of dividends expected after the explicit forecast period.

Finite-horizon stock value

The present value of holding-period dividends plus the expected sale price.

Estimated value can change substantially when growth or required-return assumptions change.

FinanceLesson 2 of 3 in the course Stocks and Stock Valuation

Dividend Discount Models: Growth Assumptions, Terminal Value, and Limitations

5 flashcards · 5 quiz questions · 5 match pairs · 5 fill-in sentences · English

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Summary

The dividend discount model (DDM) estimates a stock’s intrinsic value from the dividends an investor expects to receive. This lesson introduces the model’s logic and the role of present value in stock valuation.

A financial asset is valued by estimating the cash flows its owner expects to receive and discounting those cash flows to the present using a required rate of return. For a dividend-paying stock, the relevant cash flows are the dividends received while holding the shares. If the investor eventually sells the stock, the sale price also reflects the value of the dividends that future owners expect to receive.

All flashcards

Zero-growth DDM: Values a fixed annual dividend paid indefinitely as $P_0=D/r$ .
Gordon growth model: Values dividends growing at a constant rate using $P_0=D_1/(r-g)$ , with $r>g$ .
Terminal value in a two-stage DDM: The value at year $N$ of dividends expected after the explicit forecast period.
Finite-horizon stock value: The present value of holding-period dividends plus the expected sale price.
DDM sensitivity: Estimated value can change substantially when growth or required-return assumptions change.

Quiz questions

Which formula values an unchanged annual dividend paid indefinitely?Answer: $P_0=D/r$
For the Gordon growth formula to produce a meaningful finite value, which condition must hold?Answer: $r>g$
In a two-stage DDM with explicit forecasts through year $N$ , when is terminal value calculated?Answer: At the end of year $N$
For an investor holding a stock for $n$ years, what cash flows are included in its finite-horizon value?Answer: Dividends during the holding period and the expected sale price
Why is a conventional DDM generally unsuitable for direct valuation of a company that pays no dividends?Answer: It has no dividend stream to use as the model's direct cash flows

Based on Principles of Finance by Julie Dahlquist, Rainford Knight (OpenStax), licensed CC BY 4.0. Adapted into a summary, flashcards and quizzes.

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