Discounting Dividends and Terminal Value in a Dividend Model
Summary
The document explains how to value a company at different dates using a dividend discount model. Each dividend is discounted for the time remaining until payment, and the terminal value is discounted back from the end of the explicit forecast period. The example treats values at each fiscal year end as ex dividend, so the dividend paid at that date is excluded from the value; a cum dividend value would include it.
The answer describes terminal value as the present value of dividends beyond the forecast horizon, using a perpetual constant dividend and a constant terminal discount rate. It notes that the terminal dividend is generally based on the final forecast dividend and assumed growth. The discussion warns that estimates depend strongly on the terminal rate, that discount rates and cash flows must use the same currency, and that the valuation assumes real values adjusted for inflation. It provides conceptual guidance rather than company data or a worked numerical valuation.
Key ideas
- Discount each forecast dividend according to the time between the valuation date and its payment.
- The example values are ex dividend, while a cum dividend value includes the dividend due to the holder.
- Terminal value represents dividends beyond the explicit forecast period under a perpetual dividend assumption.
- Use cash flows and discount rates expressed in the same currency.
- Terminal discount rate assumptions materially affect valuation and should be applied consistently and stated clearly.
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Full text
# Discounting dividends and terminal value in valuation
# Discounting dividends and terminal value in valuation
I am new to finance and valuation in particular. I have a query regarding discounting dividends and terminal value for valuation using dividend discount model.
I have created an illustration to help in understanding how many years do we have to discount to find the total equity (which is then divided by number of shares to find the value of share)
Suppose I wish to value the firm for 1)Today 2) FYE2015 3) FYE2016 4) FYE 2017 with reference to the image below.
Can you tell me if my understanding is correct?
1) TODAY:
```
x/(1+r) + y/(1+r)^2 + z/(1+r)^3 + TV/(1+r)^3
```
2) FYE2015
```
y/(1+r) + z/(1+r)^2 + TV/(1+r)^2
```
3) FYE 2016
```
z/(1+r) + TV/(1+r)
```
4)FYE 2017
```
TV
```
If this is incorrect, then what should it be?
## Answer by Sergey Bushmanov (score 1, accepted)
https://quant.stackexchange.com/a/21420
> Can you tell me if my understanding is correct?
Yes it's correct, with minor clarification: you're valuing "ex dividend", meaning for FY2017, e.g., you're valuing the company the next moment the dividend was paid out. Should you be interested in "cum dividend" value, you'd add the value of dividends for the year you are entitled for.
> ...then what should it be?
Assuming what you wrote is correct, Terminal Value (TV) in Dividend Discount Model is Present Value of all future dividend inflows. Generally speaking, TV will be: $$TV=\frac{d_t}{r_t}$$
where $d_t$ is constant dividend paid forever (follows from definition of "terminal"), usually assumed equal to $z*(1+r_t)$, and $r_t$ is constant discount rate applicable to terminal period.
Beware of three caveats:
- All values are real (cleaned of inflation)
- You can't "port" rates estimated for one currency, say dollar, to cash flows estimated in another currency, say peso. You should carry out the total valuation exercise, including estimation of dividends and discount rates, in a single currency.
- There will be a certain leeway in estimating $r_t$, to which the model is very sensitive. The right thing here is not to find the "right" $r_t$ that does not exist, but to (i) apply it consistently to all your valuation universe of companies so that your relative valuation is right (ii) make your assumptions transparent so that they can be discussed (iii) make it comply to common sense.Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.