Explain terminal value and the different ways of setting it in a DDM
The idea
Multistage models forecast dividends explicitly for a few years and capture everything afterwards in a terminal value at the end of the horizon. One approach applies the constant-growth model: terminal value at year n equals D(n+1) ÷ (r − gL), which needs a sustainable long-run growth rate below r. Another applies a multiple, such as a justified or peer P/E, to forecast earnings at the horizon. A multiple ties the terminal value to market evidence but imports any mispricing of the peers. Terminal value is often most of the total, so the choice of long-run growth or multiple deserves care. The usual errors are using Dn rather than D(n+1) in the formula, or discounting the terminal value for n + 1 periods.
In the app: 1 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →More in Discounted Dividend Valuation
- Contrast dividends, residual income and free cash flow as DCF inputs and say in which investment settings each one fits
- Work out the value of a common share with the dividend discount model (DDM) over one holding period and over several, and explain the result
- Value a common share with the Gordon growth model, explaining what that model assumes
- Value perpetual preferred stock that pays a fixed rate and cannot be called
- Set out what the Gordon growth model does well and badly and argue for using it to value a firm's common shares
- Use the current share price and the Gordon growth model to back out the implied dividend growth rate, and explain it
- Work out PVGO (the present value of what future growth opportunities are worth) and the share of the leading P/E it accounts for, and explain both
- Derive justified leading and trailing P/Es from the Gordon growth model and explain what they mean
- Back out a required return from any DDM, including the H-model and the Gordon growth model
- Judge from a DDM value whether the market is pricing a stock too high, too low or fairly
- Explain the growth, transition and maturity phases a business passes through
- Explain what spreadsheet modelling, the H-model, the two-stage DDM and the three-stage DDM assume, and argue for choosing one to value a firm's shares
- Value common shares with the H-model, the two-stage DDM and the three-stage DDM, and explain the results
- Explain how spreadsheet models are used to project dividends and value common shares
- Work out a firm's sustainable growth rate and explain it, showing how DuPont analysis can be used to estimate that rate