DDM Application

Hi see if you can help to clarify some of my confusions here. ABC company latest annual dividend payment is $1.25 per share. Assume required rate of return k=12% and dividend growth rate g=8% (assuming it can be maintained indefinitely). The max price you’d be willing to pay ABC stock is $33.75. What will be the market price at the end of year 3?

p3=d4/k-g----, p3= d0*(1.08)4/k-g, p3= 42.51 is the market price

1.25*1.08/1.12 = PV of dividend year 1 1.25*(1.08/1.12)^2= PV of dividend year 2 1.25*(1.08/1.12)^3 = Pv of dividend year 3 End of year 3 would also bring in the stock price, having a PV of Stock price/(1.12^3) Max price paid for the stock = PV of dividend year 1+PV of dividend year 2+PV of dividend year 3+PV of year 3 Stock price 33.75=1.2054+1.1623+1.1208+X/1.4049, solve for X=42.5165 Alternatively, use your BAII plus CF sheet: CF0=-33.75 CF1=1.25*1.08 F1=1 CF2=1.25*1.08^2 F2=1 CF3=1.25*1.08^3 F3=1 Solve for NPV, at a I=12, that NPV=-30.2615 would represent (Stock price in year 3)/1.12^3 NPV=-30.2615=(Stock price in year 3)/1.12^3

Thx, map1. I need more practice of using BAII plus. That will save quite sometime in exam. By the way, from ssdnola’s calculation, can I derive the following? Price in year t = (Dividend in year t+1) / k-g If so, that will actually simplify the calculation - although map1’s calculation is clearer for me theoretically.

The DDM in one stage applies with certain conditions (constant growth, growth lower than required return, payment of dividend). ssdnola’s way is the most correct way to apply the DDM model, the more direct way, I would STRONGLY suggest you use it in the exam (given conditions to apply it). I thought of describing it so that you will understand the concept behind and be able to apply that even to multiple stage DDM.

I agree. Very helpful. Appreciated.

A possibly helpful shortcut that works with constant dividend growth stocks is to realize that since the denominator (k-g) is a constant, the the stock price increases each year by the same rate as the dividends do. So, the price at t=3 equals the future value of the current price, or P(3) = P(0) x (1+i)^3 = 33.75 x (1.08)^3 Or, PV=33.75; N=3; I=8; FV=??=42.52 NOTE: This method only works for constant dividend growth stocks, and not for non-constant growth stocks.

hi, this is an example of gordon growth or constant growth model where po=d/k-gc as latest divident is $1.25,i.e, Do= $1.25 D1= $1.35(1.25*1.08) D2= $1.46(1.25*1.08^2) D3=$1.57(1.25 *1.08^3) D4=$1.70(1.25 * 1.08^4)( As the queation has asked for stock value at end of 3rd year which means begining of 4th year) p3= D4/K-Gc = 1.70/12-8 = 42.52 also as $42.52>$33.75( the stock is a buy)