Stock Valuation , Two-Stage Dividend Discount Model

Stock Valuation

Section: 7 Two-Stage Dividend Discount Model

How would we value a stock that is experiencing a high rate of growth in its dividends but is expected to have a normalized growth rate in a few years? For such stocks, we would have to divide the cash flows in two phases based on the rate of growth. Also, we would make the assumption that the stock would be sold in the last year of the above average growth. Hence, we would have two sets of cash flows: i) Dividends received in years of above normal growth ii) Price of the stock at which it is assumed to have been sold in the last year of above average growth.

t = n

t = 1

Dividends

______________

(1+Ks)^t

Terminal Price n

___________________

(1 + Ks)ⁿ

Lets take an example to clarify the concept. Assume that the stock in the previous section is expected to have a dividend growth of 6% in the next three years and 3% from then onwards. First, we need to find its terminal value. For its calculation, we will use the normal growth rate to be attained in later phase.

Terminal Value

_______

Ks-g

2.45

___________

0.12 - 0.03

SR 27.26

Remember, you will receive the terminal value at the end of year 3. Now, we will discount all future cash flows.

2.12

_____

1.12

2.25

_______

(1.12)²

2.38 + 27.26

____________

(1.12)³

SR 24.78

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