Basic FinanceUnit 58 min read

Stock Valuation & Dividend Discount Models (DDM)

Unit 5 of Basic Finance explores how to value common stocks using dividend discount models (DDM), including constant growth, zero-growth, and non-constant growth scenarios, while linking theory to real-world Nepali and global applications like NEPSE stocks, eSewa dividends, and Pathao’s equity financing.

Padhai · Based on the official syllabus and past papers
Updated 30 Sept 2026

TAKEAWAYS:

Dividend Discount Model (DDM) values stocks by discounting future dividends to present value, assuming dividends reflect intrinsic worth.
Three DDM variants: Zero-growth (perpetual dividends), constant-growth (Gordon Growth Model), and multi-stage growth (changing growth rates).
Key inputs: Required return (discount rate), dividend growth rate, and terminal value (for multi-stage models).
Real-world ties: NEPSE-listed companies (e.g., NMB Bank) use DDM for share pricing; eSewa’s dividend policy reflects investor expectations.
Limitations: Assumes dividends are the sole value driver and ignores non-dividend cash flows (e.g., buybacks).
Exam focus: Numerical problems (e.g., calculating stock price given dividends/growth) and conceptual questions (e.g., why DDM fails for non-dividend stocks).

1. What is Stock Valuation?

Stock valuation estimates the intrinsic value of a company’s equity by analyzing its future cash flows (primarily dividends) and discounting them to present value. Unlike market price (which fluctuates daily), intrinsic value is a theoretical "fair price" based on fundamentals.

Why does this matter?

Investors (e.g., NEPSE traders) use it to decide whether a stock is overvalued or undervalued.
Companies (e.g., NMB Bank) use it to justify share buybacks or dividend policies.
Regulators (e.g., SEBON) scrutinize valuations for IPOs or mergers.

2. The Dividend Discount Model (DDM): Core Idea

DDM states:

Stock Price = Present Value of All Future Dividends

DDM treats a stock as the present value of all future cash flows (dividends) discounted back to today.

Mathematically: $P_{0} = t = 1 \sum \infty \frac{D _{t}}{( 1 + r ) ^{t}}$ where:

$P_{0}$ = Current stock price
$D_{t}$ = Dividend at time $t$
$r$ = Required return (discount rate, often = cost of equity)

Assumption: Dividends are the only source of return (ignores capital gains from price appreciation).

3. Three Types of DDMs

DDMs vary based on dividend growth patterns. Below is a comparison table of the three models:

Model	Dividend Growth	Formula	When to Use	Example
Zero-Growth DDM	Dividends never grow ( $g = 0$ )	$P_{0} = \frac{D}{r}$	Mature firms (e.g., utility stocks)	NTC’s perpetual dividend policy
Constant-Growth DDM	Dividends grow at fixed $g$	$P_{0} = \frac{D _{1}}{r - g}$	Stable firms (e.g., NMB Bank)	Sagarmatha Company (10% growth)
Multi-Stage DDM	Growth changes over time	$P_{0} = \sum \frac{D _{t}}{( 1 + r ) ^{t}} + \frac{P _{T}}{( 1 + r ) ^{T}}$	High-growth firms (e.g., Daraz pre-IPO)	Pathao’s early-stage vs. mature phase

4. Worked Example: Constant-Growth DDM (Gordon Growth Model)

Scenario: Sagarmatha Company paid a dividend of Rs 8 last year ( $D_{0} = 8$ ). Analysts expect dividends to grow at 10% annually forever. If the required return ( $r$ ) is 15%, what is the fair stock price?

Gordon Growth Model: Dividends grow at **8%**, discounted at **10%** (r = 10%, g = 8%).

Step-by-Step Solution

Identify inputs:
- $D_{0} = 8$ (last year’s dividend)
- $g = 10%$ (growth rate)
- $r = 15%$ (required return)
Calculate $D_{1}$ (next year’s dividend): $D_{1} = D_{0} \times (1 + g) = 8 \times 1.10 = Rs 8.80$
Apply Gordon Growth Model: $P_{0} = \frac{D _{1}}{r - g} = \frac{8.80}{0.15 - 0.10} = \frac{8.80}{0.05} = Rs 176$

Interpretation: The stock is fairly valued at Rs 176. If the market price is higher (e.g., Rs 200), it may be overvalued.

5. Real-World Applications in Nepal

Example 1: NEPSE Stocks (NMB Bank)

Idea Used: Constant-Growth DDM
How? NMB Bank’s dividends grew at ~8% annually. An investor using $r = 12%$ and $D_{0} = 15$ would calculate: $P_{0} = \frac{15 \times 1.08}{0.12 - 0.08} = \frac{16.2}{0.04} = Rs 405$ If the stock trades at Rs 350, it’s undervalued.

Example 2: eSewa’s Dividend Policy

Idea Used: Zero-Growth DDM (if dividends are stable)
How? eSewa’s parent company (F1Soft) declares fixed dividends to shareholders. If $D = 5$ and $r = 10%$ , the intrinsic value is: $P_{0} = \frac{5}{0.10} = Rs 50$ This justifies why eSewa’s shares (if traded) would reflect this valuation.

Example 3: Pathao’s Equity Financing

Idea Used: Multi-Stage DDM
How? Pathao raised funds by promising high growth initially ( $g_{1} = 20%$ ) but stabilizing later ( $g_{2} = 5%$ ). Investors discounted:
- Stage 1 (Years 1–5): High dividends (if any) at 20% growth.
- Stage 2 (Year 6+): Terminal value calculated using constant growth.

6. Limitations of DDM

While powerful, DDM has critical flaws:

Ignores Non-Dividend Cash Flows: Buybacks, stock splits, or capital gains are excluded.
Sensitive to Inputs: Small errors in $r$ or $g$ drastically change $P_{0}$ .
Assumes Perpetuity: Unrealistic for firms with finite lifespans (e.g., startups).
No Growth Firms: Fails for companies that never pay dividends (e.g., Amazon in its early years).

Mermaid Diagram: DDM’s Blind Spots

mindmap
  root((DDM Limitations))
    Ignores Buybacks
    Sensitive to r and g
    Assumes Perpetuity
    Fails for No-Dividend Firms

7. Numerical Problem: Zero-Growth DDM

Question: Kathmandu Retail Shop pays a fixed annual dividend of Rs 200. If investors require a 12% return, what is the stock’s intrinsic value?

Solution: $P_{0} = \frac{D}{r} = \frac{200}{0.12} = Rs 1, 666.67$ Answer: The stock should trade at Rs 1,667.

8. Exam Tip: How to Score Full Marks

Memorize the Three DDM Formulas:
- Zero-growth: $P_{0} = \frac{D}{r}$
- Constant-growth: $P_{0} = \frac{D _{1}}{r - g}$
- Multi-stage: Break into stages + terminal value.
Show All Steps:
- Always write $D_{1} = D_{0} \times (1 + g)$ explicitly.
- Label $r$ as "required return" and $g$ as "growth rate."
Watch for Traps:
- Growth rate ( $g$ ) must be < $r$ : If $g \geq r$ , the denominator becomes zero or negative → model breaks.
- Units matter: Ensure dividends and returns are in the same currency/time period (e.g., annual vs. monthly).
Real-World Linking:
- In essay questions, connect DDM to NEPSE stocks, dividend policies of Nepali banks, or startup valuations (e.g., Pathao).
Practice Past Papers:
- Questions often mix DDM with WACC (Unit 7) or cost of equity (Unit 4). Example:
  
  "If a firm’s cost of equity is 14% and dividends grow at 8%, calculate its stock price given $D_{0} = 5$ ." Solution: $P_{0} = \frac{5 \times 1.08}{0.14 - 0.08} = \frac{5.4}{0.06} = 90$ .

9. Common Mistakes to Avoid

Mistake	Why It’s Wrong	How to Fix
Using $D_{0}$ instead of $D_{1}$	Dividends grow after the current period.	Always calculate $D_{1} = D_{0} \times (1 + g)$ .
Ignoring $g < r$ rule	Leads to division by zero or negative prices.	Check $g < r$ before applying the formula.
Mixing nominal/growth rates	Inflation can distort real growth.	Use real rates if comparing across time.
Forgetting terminal value in multi-stage	Underestimates long-term worth.	Always include $P_{T} = \frac{D _{T + 1}}{r - g}$ for Stage 2.

10. Visual Summary: The Accounting Cycle of DDM

Based on the TU BBA syllabus for Basic Finance (FIN211), unit 5.

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