CFA® Level II · Equities · free lesson

Discounted Dividend Valuation

Dividend discount models value a share as the present value of the dividends a shareholder expects to receive, and they underpin justified multiples and terminal values throughout equity analysis. This module compares dividends with free cash flow and residual income, applies the Gordon growth model to common and preferred shares, extracts implied growth, required return and PVGO from prices, derives justified P/E ratios, and builds two-stage, H-model and three-stage valuations anchored on sustainable growth. Level II item sets chain these steps, so precision with D0 versus D1, H and the terminal year matters.

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What you will learn

1. Compare dividends, free cash flow and residual income as definitions of the cash flow to be valued, and match each to the situations where it works best.

Dividends: stable, easy to forecast, minority perspective; suit established payers with policy tied to earnings.
Free cash flow: what could be paid out; control perspective; suits non-payers and companies whose dividends differ from capacity.
Residual income: earnings above a charge for equity capital; suits negative-FCF companies with reliable accounting and financial firms.
Consistent models should give similar values; a big gap signals inconsistent assumptions or distorted accounts.

2. Value common shares with the Gordon growth model and perpetual preferred shares as perpetuities, and back out the implied growth rate, implied required return and the present value of growth opportunities.

V0 = D1 / (r - g) with D1 = D0(1 + g); valid only when g < r and growth is sustainable forever.
Perpetual preferred value = D / r_p.
Implied required return = D1/P0 + g; implied growth = r - D1/P0.
V0 = E1/r + PVGO; PVGO is positive only if new investments earn more than r.
The model is very sensitive to the spread r - g.

3. Derive justified leading and trailing P/E ratios from the Gordon growth model and use them to judge whether a share is fairly priced.

Justified leading P/E = (1 - b)/(r - g); justified trailing P/E = (1 - b)(1 + g)/(r - g).
Trailing exceeds leading by the factor (1 + g); compare like with like.
Other things equal, the justified P/E rises with payout and growth and falls with r.
Retention raises the P/E only if ROE exceeds r.
Market P/E above justified P/E suggests overvaluation relative to the analyst's fundamentals.

4. Value shares with two-stage, H-model and three-stage dividend discount models, including the terminal value, and solve for the required return they imply.

Two-stage: PV of high-growth dividends + PV of V_n = D_(n+1)/(r - g_L), discounted n years.
H-model: V0 = D0(1 + gL)/(r - gL) + D0 H (gS - gL)/(r - gL); growth falls linearly over 2H years.
Implied r from the H-model: r = (D0/P0)[(1 + gL) + H(gS - gL)] + gL.
Three-stage: explicit stages plus Gordon terminal value, or explicit stage plus an H-model valued at the end of it.
The terminal value dominates; mature growth must be consistent with mature ROE and payout.

5. Estimate sustainable growth from the retention ratio and return on equity, using DuPont analysis to identify its drivers.

Sustainable growth g = b x ROE, assuming constant ROE, payout and capital structure and no new equity.
DuPont: ROE = net profit margin x asset turnover x financial leverage.
Growth can come from retention, margin, turnover or leverage; leverage-driven growth adds risk.
ROE inflated by buybacks or a shrunken equity base overstates sustainable growth.
Use mature ROE and payout for the stable stage of a multistage model.

Module at a glance

Dividends suit minority investors in steady payers; free cash flow suits control and non-payers; residual income suits negative-FCF firms with reliable accounts.
Gordon value = D1 / (r - g); perpetual preferred = D / r; always grow D0 to D1.
Implied return = D1/P0 + g; PVGO = price - E1/r and is positive only if new investment earns more than r.
Justified leading P/E = payout / (r - g); trailing = leading x (1 + g).
Two-stage terminal value = D(n+1) / (r - gL), discounted n years; the H-model adds D0 x H x (gS - gL) / (r - gL) with H = half the fade period.
Sustainable growth = retention x ROE, with ROE = margin x turnover x leverage; use mature values for the stable stage.

This free module has 5 lessons, 16 practice questions with full explanations.

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