I was revising the reading on Equity valuvation tools and I think there is something wrong with the logic of the DDM formula (or something wrong with my thinking ).
Basically it says the cost/price of the share = PV of future cash flows
where FCF are div . then cost/price = PV of the future div .
So given a table of div to be received .
d0 = 10
d1=12
d2=14.4
d3=17.28
d4= …so on
Where growth = 2% , Ke= 10% .
So now the value of the stock during the period 2 = PV of all the div recieved from period 3 right ?
so in that case the forumla of d3/ke-g = Pv of fcf is wrong ? because it seems to take into account only the Div. which is available in the 3rd period and not the other div. which we recieve from period 4 and so on … ?
thanks for taking the time to reply . I will try to reframe the question .
The discounted div model , is used for Equity valuvation and according to the model (atleast the logic behind it) is that the PV/Price of a stock is the PV of the future Inflows which we recieve . So …, dam ! i got it ! Thanks Pompey .
Btw , D0 is not taken into account for calculation of the PV of a stock , as D0 represents the dividend which has already been recieved and is not a “future cash flow” anymore .
MY doubt was that why is the PV of d3 payement = D3/ke-G . only then ir ealised that the “-G” factors in the growth% and its a perpetuity . Hence , the formula .
Althoguh it would be awesome if S2000 , could shed some more light on the DDM model .
Oh another small question , can we use the the financial calc. like we did in the TVM for calculation ? (except we need to factor in the G%) .
The DDM formula is the formula for the present value of a growing perpetuity. The better way to frame it is
PV(t) = CF(t+1)/(r-g) (i.e. the vaue at time “t” is based on the next period’s cash flow)
where
t is a time index (i.e. PV(2) would bee the present value “as of time 2”),
r = the discount rate (or requiredrate of return)
g = the constant growth rate in cash flows
You can use the formula whenever (starting with the NEXTperiod’s cash flow), all subsequent cash flows grow at a constant rate.
So, in the example above, the cash flows are the dividends. The value of the stock at time=2 is the present value of all cash flows occurring after time 2 (i.e. PV(2)) = 17.28/(0.10-0.02) = 216
So, the stock is projected to bee worth $216 in year 2. This figure represents the value (actually the Present Value) of all dividends occurring after that point. So, if you bought the stock,you’re receive the following cash flows:
Year 0: $0 (you don;t get D(o) - it goes to the last guy who owned the stock
Year 1: $12 (the first year dividend)
Year 2: $230.40 (the $14.40 dividend PLUS the stock value of $216). You could think of this as getting the dividend and then selling the stock for $216.
As visual, picture the dividends as a long carpet that stretches forever. Calculating the stock price at year 2 is equivalent to rolling up the carpet to year 2 in the first step. This value takes care of all of the carpet taking place AFTER year 2. Then you roll it (along with the first two years’ dividends) up to time 0 in the second step.