What Is the Multistage Dividend Discount Model and How Does It Work?

Valuing a company’s stock can be challenging, especially when dividend payments fluctuate. The multistage dividend discount model (DDM) addresses this by breaking valuation into distinct growth phases, making it useful for companies with changing dividends. This approach is more flexible than models that assume constant growth.

To understand this model, it’s important to examine growth stages, dividend projections, and how discount rates determine present value.

Stages of Growth

Companies rarely expand at a uniform pace, so the multistage DDM divides their development into phases. Businesses typically experience rapid early growth, followed by a more stable expansion, and eventually settle into a mature phase with steady growth.

Early on, firms reinvest most earnings to fund expansion, limiting dividends. This is common in industries like technology and biotechnology, where companies prioritize research, development, and market penetration. Dividends may be minimal or nonexistent as profits are reinvested.

As a company matures, earnings become more predictable, allowing for a structured dividend policy. Growth rates remain above average but begin to stabilize as market share solidifies and expansion slows. Established consumer goods and industrial firms often fall into this category, increasing dividends while still reinvesting for moderate growth.

Eventually, most companies reach a stage where expansion slows further, and earnings growth aligns with the broader economy. At this point, firms prioritize shareholder returns over reinvestment. Utilities and large-cap blue-chip stocks often fall into this category, offering reliable dividends with lower volatility.

Dividend Calculations

Estimating future dividends requires accounting for projected growth rates in each phase. The multistage DDM forecasts dividends for specific periods before discounting them to determine present value. Analysts assess historical payout trends, earnings stability, and industry norms to develop reasonable projections.

For high-growth companies, dividends may start small but increase rapidly. This requires calculating expected payouts for each year individually. If a firm currently pays $1 per share and expects a 15% annual increase for five years, the projected dividends would be:

– Year 1: $1.15
– Year 2: $1.32
– Year 3: $1.52
– Year 4: $1.75
– Year 5: $2.01

Each payment must then be discounted to present value.

As companies transition into a stable phase, dividend growth rates moderate. Instead of forecasting each year separately, analysts apply a constant growth assumption. If dividends are expected to rise by 5% annually after the high-growth phase, the first-year payout in this stage serves as the baseline for future calculations. This simplifies valuation while capturing financial shifts.

Finding the Required Return Rate

Determining the appropriate return rate is fundamental when valuing a stock using the multistage DDM. This rate, known as the discount rate, represents the return investors expect based on the company’s risk and market conditions.

A widely used method for calculating return is the Capital Asset Pricing Model (CAPM), which considers the risk-free rate, stock beta (volatility relative to the market), and equity risk premium.

For example, if the risk-free rate is 4%, the stock’s beta is 1.2, and the equity risk premium is 6%, the required return would be:

4% + (1.2 × 6%) = 11.2%

Some analysts adjust for company-specific risks not fully captured by beta, such as regulatory uncertainty or industry disruptions. If historical stock performance suggests a different return than CAPM predicts, adjustments may be made.

Terminal Value Approaches

Since companies operate indefinitely, projecting dividends far into the future becomes uncertain. The multistage DDM uses a terminal value to estimate the stock’s worth beyond forecasted periods, consolidating future dividends into a single figure discounted to present value.

A common method for calculating terminal value is the Gordon Growth Model, which assumes dividends grow at a steady rate indefinitely:

TV = D_n+1 / (r – g)

where D_n+1 is the projected dividend in the first year after the forecast period, r is the required return, and g is the perpetual growth rate.

Selecting a reasonable growth rate is crucial. Overly optimistic assumptions inflate value, while conservative estimates may undervalue the stock. Analysts often reference historical inflation trends or GDP growth to keep projections realistic.

Combining All Elements

Applying the multistage DDM requires integrating projected dividends, discount rates, and terminal value calculations. Each growth stage must be assessed individually before combining them into a single valuation.

The process begins by discounting each forecasted dividend using the required return rate. This ensures near-term cash flows are properly weighted against future expectations. Once explicitly projected dividends are accounted for, the terminal value is calculated and discounted. Summing these components provides the estimated intrinsic value of the stock.

If this valuation exceeds the market price, the stock may be undervalued, presenting a potential investment opportunity. Conversely, if the calculated value is lower than the market price, it could indicate overvaluation.