Multistage Dividend Discount Model: Essential Insights for Investors

Charlene Rhinehart, CPA and CFE, chairs an Illinois CPA Society committee and holds degrees in accounting and finance from DePaul University.

Definition: The multistage dividend discount model is a sophisticated equity valuation technique that refines the Gordon growth model by applying multiple dividend growth rates across distinct time frames to accurately value dividend-paying stocks.

What Is the Multistage Dividend Discount Model?

This model enhances the traditional Gordon growth approach by integrating different growth phases, allowing for more realistic valuation of companies whose dividend growth rates fluctuate over time. Variants include the two-stage, H-model, and three-stage dividend discount models.

Understanding the Multistage Dividend Discount Model

The Gordon growth model calculates the present value of an infinite series of dividends assuming a constant growth rate, making it ideal for stable, blue-chip companies with predictable dividend patterns.

• The multistage dividend discount model expands on the Gordon model by incorporating multiple growth rates tailored to different periods.
• It offers practical valuation for companies with dividend patterns that reflect cyclical business environments.
• This model accommodates fluctuations in financial performance, including both typical and extraordinary events.
• Its initial growth rate phase is variable and can be either positive or negative, reflecting real-world volatility.

By allowing for an unstable initial growth phase followed by perpetual stable growth, the multistage dividend discount model provides a nuanced framework for assessing most dividend-paying companies that experience economic cycles and financial irregularities.

However, one limitation is the assumption that growth rates stabilize abruptly after the initial phase. The H-model addresses this by modeling a gradual decline from a high initial growth rate to a stable long-term rate. Additionally, the model assumes constant dividend payout ratios and cost of equity.

Key Consideration

This model is predominantly suited for mature, dividend-paying companies such as blue-chip firms.

The three-stage model further refines valuation by incorporating an initial period of high stable growth, followed by a linear decline to a sustainable growth rate, making it applicable to a broad range of companies.

Multistage Dividend Discount Model Within the Spectrum of Equity Valuation Methods

Equity valuation techniques are generally categorized into absolute (intrinsic) and relative valuation methods. Dividend discount models, including the Gordon and multistage variants, fall under absolute valuation alongside discounted cash flow (DCF), residual income, and asset-based approaches.

Relative valuation methods involve comparing financial multiples, such as price-to-earnings (P/E) ratios, against those of similar companies to derive value.

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