We have discussed the basic concepts of Dividend Discount Model (DDM) and demonstrated how it can be used to valuate preferred stock and simple growing common stock. This video continues the discussion by looking into a more complicated example. The following is a part of the transcript. This video requires Flash 8 or above. If it does not start, click the play button to start.

Assume there is a stock S. You expect the company to grow at a rate of 30% (g1=30%) in the coming 2 years. After that, the company will grow at a rate of 5% (g2=5%) forever. Assume the required rate of return is 10% and the company has just paid $1 dividend (D0=1). What is the price of the stock today?

Looks like complicated. But this again is just a cash flow problem. Try to list the cash flow in every year and apply the appropriate discount rate. Then you can find the price.

1 year later: Dividend = D1 = D0 * (1+30%) = 1.3

2 years later: Dividend = D2 = D1 *(1+30%) = 1.69

After that dividend will grow at 5% every year, so this is an infinite period DDM. So, ask yourself, what is the price of the stock 2 years later? You then find that you can just use this equation:

P2 = D2 * (1+g2)/(k-g2) = 35.49

This means that if you sell the stock 2 years later, the cash in-flow is $35.49. This is equivalent to holding the stock forever by just receiving the dividends every year! But 35.49 is the value 2 years later, so you have to discount it to today’s value. Therefore the price of the stock today is

P = D1/(1+k) + D2/(1+k)^2 + P2/(1+k)^2 = $31.9

Please see the videos for details.