Stock Valuation & Dividend Discount Models (DDM)

Key Concepts in Stock Valuation

Stock valuation determines the fair price of a stock based on its future cash flows (dividends) and risk. The Dividend Discount Model (DDM) is the most fundamental approach, assuming a stock’s value equals the present value (PV) of all future dividends.

1. Dividend Discount Model (DDM) Basics

The core idea: A stock’s price today is the sum of all future dividends discounted back to present value.

Formula: $$P_0=\sum _{t=1}^{\infty }\frac{D_t}{(1+r{)}^t}$$ Where:

• $P_0$ = Current stock price
• $D_t$ = Dividend at time $t$
• $r$ = Required rate of return (discount rate)

Types of DDM

2. Constant-Growth Dividend Discount Model (Gordon Growth Model)

Used when dividends grow at a steady rate (e.g., mature companies like Ncell or NTC).

How It Works

• Assumes dividends grow forever at rate $g$.
• Requires $r>g$ (otherwise, the model breaks down).

Example: A stock pays Rs. 40 dividend last year, growing at 6%. If the required return is 12%, what’s its price?

$$P_0=\frac{D_1}{r-g}=\frac{40\times 1.06}{0.12-0.06}=\frac{42.4}{0.06}=\text{Rs. 706.67}$$

3. Variable-Growth Dividend Discount Model (Two-Stage DDM)

Used when dividends grow at different rates (e.g., a company in high-growth phase transitioning to maturity).

Example: Daraz (Alibaba’s Nepal arm)

• Stage 1 (High Growth): Dividends grow at 15% for 5 years.
• Stage 2 (Stable Growth): Dividends grow at 5% forever.
• Last dividend ($D_0$) = Rs. 10, required return ($r$) = 12%.

Step 1: Calculate dividends for first 5 years. Step 2: Find terminal value at Year 5 using Gordon Growth Model. Step 3: Discount all cash flows back to Year 0.

4. Non-Dividend-Paying Stocks (Zero-Dividend Stocks)

Some stocks (e.g., NEPSE-listed tech startups) don’t pay dividends but may be sold later.

Valuation Approach:

• Use free cash flow (FCF) discounting instead of dividends.
• Formula: $$P_0=\sum _{t=1}^{\infty }\frac{FC{F}_t}{(1+r{)}^t}$$

5. Real-World Applications in Nepal

📌 NEPSE Stock Valuation (e.g., NMB Bank)

• NMB Bank pays dividends growing at ~8%.
• If last dividend was Rs. 20, and required return is 14%, its fair price is: $$P_0=\frac{20\times 1.08}{0.14-0.08}=\text{Rs. 360}$$

📌 eSewa & Khalti (Digital Payment Apps)

• No dividends, but valued based on future cash flows (transaction fees).
• Investors use FCF models to estimate their worth.

📌 Pathao (Ride-Hailing App)

• Growth-stage company → Two-stage DDM applies.
• Early years: High dividend growth (if profitable).
• Later years: Stable growth.

6. Exam Tip: How to Score Full Marks

✅ Memorize the Gordon Growth Model formula—it’s tested in every exam. ✅ Always check if $r>g$—if not, the model is invalid. ✅ For variable growth, break into stages (e.g., high growth → stable growth). ✅ Compare market price vs. calculated price—if market price > fair price, it’s overvalued; if <, it’s undervalued.

📊 Visual: Dividend Growth Patterns

pie
    title Dividend Growth Models
    "Zero-Growth" : 20
    "Constant-Growth (Gordon)" : 50
    "Variable-Growth (Two-Stage)" : 30

📊 Visual: Stock Valuation Process

flowchart TD
    A["Dividend Data"] --> B["Choose DDM Model"]
    B --> C{"Is Growth Constant?"}
    C -->|"Yes"| D["Gordon Growth Model"]
    C -->|"No"| E["Two-Stage DDM"]
    D --> F["Calculate P0 = D1/(r-g)"]
    E --> G["Calculate Terminal Value"]
    F --> H["Compare to Market Price"]
    G --> H

📊 Visual: NEPSE Stock Price vs. Fair Value

📊 Visual: Dividend Discounting Timeline

(Imagine a timeline with dividends $D_1,D_2,\dots$ and their discounted present values.)

📊 Visual: Two-Stage DDM Calculation Steps

sequenceDiagram
    participant Investor
    participant Company
    Investor->>Company: Pays Rs. 100 for stock
    Company-->>Investor: Dividend D1 (Year 1)
    Company-->>Investor: Dividend D2 (Year 2)
    Note right of Company: High growth (15%)
    Company-->>Investor: Dividend D5 (Year 5)
    Note right of Company: Stable growth (5%)
    Company-->>Investor: Dividend D6 (Year 6)
    Investor->>Investor: Discount all back to Year 0

📊 Visual: Real Stock Valuation Example (Ncell)

(A real chart from NEPSE showing dividend payments and stock price trends.)

📊 Visual: Comparison of DDM Models

📊 Visual: Dividend Growth vs. Stock Price

(A graph where dividend growth rate $g$ is on the x-axis and stock price $P_0$ on the y-axis, showing the relationship.)

📊 Visual: Short Selling Margin Example (Gautam’s Case)

pie
    title Short Selling Margin Requirements
    "Initial Margin (60%)" : 60
    "Maintenance Margin (30%)" : 30
    "Equity" : 10

Final Exam Checklist

✔ Can you apply the Gordon Growth Model to a real stock (e.g., NMB Bank)? ✔ Do you know when to use two-stage DDM (e.g., Pathao)? ✔ Can you compare market price vs. fair value and decide if a stock is over/undervalued? ✔ Do you check $r>g$ before using DDM?

💡 Pro Tip:

• NEPSE stocks like NMB, Global IME, and NTC often use constant-growth DDM.
• Tech startups (if listed) may require variable-growth models.
• Always justify your answer—examiners want to see calculations + reasoning.

📚 Further Reading:

• NEPSE Annual Reports (for dividend histories).
• Investopedia’s DDM Guide (for global examples).
• Past TU exam papers (for pattern recognition).