Dividend Discount Model

Equity analysis is carried out by means of fundamental and/or technical analysis. Fundamental analysis examines the factors influencing the share price that are relevant to valuation. For this purpose, information on the overall economy, the industry, and the company are analysed. Central to fundamental analysis is a valuation model on the basis of which the intrinsic value is calculated. To arrive at an investment decision, the intrinsic value determined with the valuation model is compared with the market price. If the intrinsic value exceeds (falls below) the market price, the equity security appears to be undervalued (overvalued). The valuation models applied in fundamental analysis can be divided into absolute and relative models. The absolute models can be grouped into cash flow models and value-added models. Cash flow models include the dividend discount model, the free cash flow to equity model, and the free cash flow to firm model. This chapter presents the dividend discount model, which, like the other cash flow models, is used to calculate the intrinsic share value under the going concern assumption. According to the model, the intrinsic value equals the present value of the future dividends that investors can expect when buying stocks. For this purpose, future dividends are discounted with the expected return of the shareholders.