Basic FinanceUnit 69 min read

Stock Valuation & Dividend Discount Models: Theory, Models & Applications

Unit 6 of Basic Finance explores how to value common stocks using dividend discount models (DDM), Gordon Growth Model, and non-constant growth scenarios, with real-world applications in Nepali and global markets like NEPSE, Daraz, and Ncell.

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

TAKEAWAYS:

Dividend Discount Models (DDM) value stocks by discounting future dividends to present value, assuming dividends reflect intrinsic worth.
Gordon Growth Model simplifies valuation for stable-growth stocks using $P_{0} = \frac{D _{1}}{r - g}$ , where $D_{1}$ = next dividend, $r$ = required return, $g$ = growth rate.
Non-constant growth models (e.g., two-stage DDM) handle early high growth followed by stable growth, critical for tech stocks like Daraz.
Real-world applications: NEPSE stocks (e.g., Ncell) use DDM for valuation; banks (e.g., NMB) apply models to dividend-paying stocks.
Exam focus: Numerical problems (e.g., calculating stock price, growth rate, or required return) dominate; memorize formulas and assumptions.

1. Introduction to Stock Valuation

Stock valuation determines a stock’s intrinsic value—its true worth based on fundamentals, not market hype. Unlike bonds (fixed cash flows), stocks generate dividends (cash payments to shareholders) and potential capital gains (price appreciation). The core principle:

"A stock’s value equals the present value (PV) of all future cash flows (dividends + future sale price) an investor expects to receive."

Why Dividends Matter

Cash Flow Source: Dividends are tangible returns; capital gains are speculative.
Investor Preference: Growth investors (e.g., NEPSE’s Ncell) prioritize reinvested earnings; income investors (e.g., NMB Bank) seek steady dividends.
Market Signal: Rising dividends signal profitability (e.g., Daraz’s 2023 dividend hike post-IPO).

2. Dividend Discount Models (DDM): The Foundation

DDMs value stocks by discounting expected future dividends to present value. Three key models:

A. Zero-Growth (Perpetual) Dividend Model

Assumption: Dividends grow at 0% (constant forever). Formula: $P_{0} = \frac{D}{r}$

$P_{0}$ : Current stock price
$D$ : Current dividend (constant)
$r$ : Required return (discount rate)

Example: A stock pays Rs 5 annually with no growth. If investors require 10% return, its value is: $P_{0} = \frac{5}{0.10} = Rs 50$

B. Constant-Growth (Gordon Growth) Model

Assumption: Dividends grow at a constant rate $g$ forever. Formula: $P_{0} = \frac{D _{1}}{r - g}$

$D_{1}$ : Next year’s dividend ( $D_{0} \times (1 + g)$ )
$g$ : Growth rate (must be < $r$ ; else model fails).

Worked Example: Nepal Electricity Authority (NEA) stock

Last dividend ( $D_{0}$ ): Rs 8
Growth rate ( $g$ ): 5%
Required return ( $r$ ): 12% Calculate $P_{0}$ : $D_{1} = 8 \times 1.05 = Rs 8.40$ $P_{0} = \frac{8.40}{0.12 - 0.05} = \frac{8.40}{0.07} = Rs 120$

Validation: If NEA’s stock trades at Rs 110, it’s undervalued (intrinsic value > market price).

C. Non-Constant Growth Models

Reality Check: Most stocks (e.g., Daraz, Ncell) don’t grow at constant rates. Use:

Two-Stage DDM:
- Stage 1: High growth ( $g_{1}$ ) for $n$ years.
- Stage 2: Switch to constant growth ( $g_{2}$ ).
- Formula: $P_{0} = t = 1 \sum n \frac{D _{t}}{( 1 + r ) ^{t}} + \frac{P _{n}}{( 1 + r ) ^{n}}$ where $P_{n}$ = Gordon Growth value at year $n$ .

Example: Pathao’s IPO valuation

Stage 1: Dividends grow at 20% for 5 years.
Stage 2: Growth stabilizes at 5%.
$D_{0} = Rs 2$ , $r = 15%$ . Calculate $P_{0}$ :

flowchart TD
    A["Year 0: D0 = Rs 2"] --> B["Year 1: D1 = 2*1.20 = Rs 2.40"]
    B --> C["Year 2: D2 = 2.40*1.20 = Rs 2.88"]
    C --> D["... Year 5: D5 = Rs 4.18"]
    D --> E["Year 6+: Gordon Growth: P5 = D6/(r-g) = 4.18*1.05/(0.15-0.05) = Rs 43.90"]
    E --> F["PV of Dividends (Years 1-5) + PV of P5 = Rs 18.50 + Rs 23.00 = Rs 41.50"]

Final Value: Rs 41.50 (simplified; exact calculation requires PV of each dividend).

3. Comparing DDM Models

Model	Growth Assumption	When to Use	Limitations
Zero-Growth	$g = 0%$	Mature firms (e.g., NTC)	Rare in practice.
Constant-Growth (Gordon)	$g$ constant	Stable firms (e.g., NMB Bank)	Fails if $g \geq r$ .
Two-Stage DDM	High $g_{1}$ , then $g_{2}$	Growth firms (e.g., Daraz)	Complex; requires forecasts.

4. Real-World Applications

A. NEPSE Stocks

Ncell: Uses Gordon Growth for dividend valuation.
- 2023 dividend: Rs 12, growth: 4%, required return: 10%.
- Intrinsic price: $\frac{12 \times 1.04}{0.10 - 0.04} = Rs 208$ .
- If trading at Rs 180, it’s undervalued.

B. E-Sewa & Khalti (Fintech)

Dividend Analogy: E-Sewa’s "cashback" rewards act like dividends for users.
- Model: Treat cashback as a perpetual dividend stream.
- Example: Rs 500/year cashback, required return 8% → "Value" = $\frac{500}{0.08} = Rs 6,250$ (hypothetical user lifetime value).

C. Daraz’s IPO (2021)

Two-Stage DDM: Daraz’s high growth (20%+) post-IPO justified premium valuation.
- Stage 1 (3 years): $g_{1} = 20%$ , $D_{0} = Rs 0$ (no dividends yet).
- Stage 2: $g_{2} = 5%$ , $r = 12%$ .
- Result: IPO price set at ~Rs 1,000/share based on future earnings potential.

5. Common Pitfalls & Adjustments

Dividend Growth > Required Return ( $g > r$ ):
- Problem: Model breaks (denominator becomes negative or zero).
- Fix: Reassess growth assumptions or use free cash flow models.
Non-Dividend-Paying Stocks (e.g., Ncell’s early years):
- Solution: Use Price/Earnings (P/E) ratio or Free Cash Flow (FCF) models.
Taxes & Flotation Costs:
- Adjust $D_{1}$ for taxes: $D_{1}^{after-tax} = D_{1} \times (1 - tax rate)$ .

6. Worked Example: Kathmandu Retail Shop

Scenario: A Kathmandu shop pays Rs 50,000/year dividend, growing at 6% annually. Investors require 12% return. Questions:

What’s the shop’s intrinsic value?
If the shop sells for Rs 800,000, is it over/undervalued?

Solution:

Intrinsic Value: $P_{0} = \frac{50 , 000 \times 1.06}{0.12 - 0.06} = \frac{53 , 000}{0.06} = Rs 883,333$
Comparison:
- Market price: Rs 800,000
- Intrinsic value: Rs 883,333
- Verdict: Undervalued by Rs 83,333 (buy opportunity).

Metric	Value (NPR)
$D_{0}$	50,000
$D_{1}$	53,000
$r$	12%
$g$	6%
Intrinsic $P_{0}$	883,333

7. Exam Tip: How to Score Full Marks

Show All Steps:
- Examiners deduct marks for skipped logic. Always write:
  - Formula used.
  - Substituted values.
  - Final calculation.
Watch Units:
- Ensure $g$ and $r$ are in decimal form (e.g., 10% = 0.10).
- Example Mistake: $Wrong: P_{0} = \frac{D _{1}}{r - g} = \frac{8.40}{12 - 5} = \frac{8.40}{7} (Incorrect!)$ $Correct: P_{0} = \frac{8.40}{0.12 - 0.05} = \frac{8.40}{0.07}$
Interpret Results:
- If calculated price > market price: "Undervalued; buy."
- If calculated price < market price: "Overvalued; sell or hold."
Common Exam Questions:
- Calculate $g$ given $P_{0}$ , $D_{1}$ , and $r$ .
- Find $r$ if $P_{0}$ , $D_{1}$ , and $g$ are known.
- Example:
  
  "A stock pays Rs 10 dividend, grows at 4%, and trades at Rs 150. What’s the required return?" $r = \frac{D _{1}}{P _{0}} + g = \frac{10 \times 1.04}{150} + 0.04 = 0.0693 + 0.04 = 10.93%$

8. Summary Flowchart: The Accounting Cycle of Stock Valuation

flowchart TD
    A["Start: Identify Dividend Pattern"] --> B{"Constant Growth?"}
    B -->|"Yes"| C["Use Gordon Growth Model: \( P_0 = \frac{D_1}{r - g} \)"]
    B -->|"No"| D{"Non-Constant Growth?"}
    D -->|"Yes"| E["Use Two-Stage DDM: High \( g_1 \) → Low \( g_2 \)"]
    D -->|"No"| F["Use Zero-Growth Model: \( P_0 = \frac{D}{r} \)"]
    C --> G["Calculate Intrinsic Value"]
    E --> G
    F --> G
    G --> H["Compare to Market Price"]
    H --> I{"Intrinsic > Market?"}
    I -->|"Yes"| J["Buy (Undervalued)"]
    I -->|"No"| K["Sell/Hold (Overvalued)"]

9. Key Formulas to Memorize

Model	Formula	When to Use
Zero-Growth	$P_{0} = \frac{D}{r}$	Constant dividends.
Constant-Growth	$P_{0} = \frac{D _{1}}{r - g}$	Stable growth firms (e.g., NMB Bank).
Two-Stage DDM	$P_{0} = \sum \frac{D _{t}}{( 1 + r ) ^{t}} + \frac{P _{n}}{( 1 + r ) ^{n}}$	High-growth → stable (e.g., Daraz).

Based on the TU BBM syllabus for Basic Finance (FIN211), unit 6.

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