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A Dynamic Approach to the Dividend Discount Model

Author

Listed:
  • Natalia Lazzati

    (Department of Economics, University of Michigan, Ann Arbor, MI, USA)

  • Amilcar A. Menichini

    (Graduate School of Business and Public Policy, Naval Postgraduate School, Monterey, CA, USA)

Abstract

We derive a dynamic model of the firm with endogenous investment and leverage ratio within the framework of the dividend discount model (DDM). Our valuation model incorporates two relevant components, namely, managerial flexibility and long-run growth. We dispense with any utility specification capturing the preferences of shareholders and obtain closed-form solutions for the firm problem. A standard parameterization suggests that the value of the real options and long-run growth opportunities can easily represent more than 8% and 10% of share price, respectively. We also find that these two components of the stock price are both complements and countercyclical. We finally identify industries where valuation models that do not incorporate these features can lead to considerable underpricing of securities.

Suggested Citation

  • Natalia Lazzati & Amilcar A. Menichini, 2015. "A Dynamic Approach to the Dividend Discount Model," Review of Pacific Basin Financial Markets and Policies (RPBFMP), World Scientific Publishing Co. Pte. Ltd., vol. 18(03), pages 1-36.
    • Handle: RePEc:wsi:rpbfmp:v:18:y:2015:i:03:n:s0219091515500186
    DOI: 10.1142/S0219091515500186
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    More about this item

    Keywords

    Dividend Discount Model; Gordon Growth Model; Real Options; Long-Run Growth; Dynamic Programming; G31; G32;
    All these keywords.

    JEL classification:

    • G1 - Financial Economics - - General Financial Markets
    • G2 - Financial Economics - - Financial Institutions and Services
    • G3 - Financial Economics - - Corporate Finance and Governance

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