Confusion on Div Discount Formulas

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=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.

1 Like

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

1 Like

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

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.

1 Like