Confusion on Div Discount Formulas

CFA Level I Equities
#1

OK so I don’t understand and maybe I have missed something - can someone help explain this to me? As you can probably tell I’m way behind…

  1. Basic equations

V0=D0/r

and

V0=D1 / (r-g)

  1. There seem to be usages of two denominator formats in the practice tests -

a) 2 stage div discount model says, for g as growth rate for 2 periods and NEW as growth rate from the 3rd period onwards:

V = (Div*(1+g))/(1+R) + (Div*(1+g)^2)/(1+R)^2 + Div*(1+g)^2*(1+NEW)/(R-g) * (1/(1+R)^2)

b) and yet this one also comes up - where you are given current dividend, 3 years of growth, and compute current intrinsic value

V=Div*(1+g))/(1+R) + Div *(1+g)^2 /(1+R)^2 + Div*((1+g)^3 + Stock price)/(1+R)^3

I fully understand that the a) involves 2 growth rates and the b) does not. What I don’t get is why a) still discounts with (1+R)^2 for the third period whereas b) discounts with (1+R)^3?

Thanks for any help to clear these 2 questions up.

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#2

In your example a) the last growth rate (NEW) is the terminal value growth rate. The model assumes cash flows at the end of the period. The term Div*(1+g)^2*(1+NEW)/(R-g) is the present value of the terminal value at the beginning of period 3 = end of period 2. Hence, you discount it by 2 years, not 3.

Regards, Oscar

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#3

At least for me - it is better just to draw the line line in FV/PV problems in quant.

No need to remember those obscure formulas

#4

You still need to be aware that the PV of the terminal value always refers to the last year. This is a common mistake with or without timeline.

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