This movie/ video describes the concepts of Dividend Discount Model for security valuation. This is the first part. The following is a part of the transcript. This video requires Flash 8 or above.

To evaluate the value of a stock (preferred or common), Dividend Discount Model (DDM) is one of the common methods. DDM is based on a very basic concept – the net present value of the expected future cash flow has to be equal to the cash out flow to buy the stock. Therefore, it is very important to clarify the cash flow amount, timing and discount rate relevant to the stock.

We first illustrate this concept with preferred stock. The cash flow of a preferred stock is the simplest. Today, you pay the price (value) of the preferred stock. And every year you receive a fix dividend (D). If you don’t sell the stock, you will receive the dividend forever. So at what price are you willing to pay for the stock?

Obviously, the maximum stock value you are willing to pay is the net present value of the dividend. The net present value is:

D/(1+k) + D/(1+k)^2 + D/(1+k)^3+…+D/(1+k)^10000+…

where k is the appropriate discount rate.

So, this is the maximum price (P) you are willing to pay for the stock.

Please make sure you understand why the equation is so. After that, you should be able to derive the price of any stock using DDM.

Of course, you are not going to find the price by calculating infinite number of terms. Fortunately, the P of a preferred stock is just the sum of a geometric series and it can be simplified to the following equation:

P = D/k

Please note that k is in decimal. So, if k is 9%, put it as 0.09.