A Dynamic Approach to the Dividend Discount Model

Natalia Lazzati () and Amilcar A. Menichini ()
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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

Review of Pacific Basin Financial Markets and Policies (RPBFMP), 2015, vol. 18, issue 03, 1-36

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.

Keywords: Dividend Discount Model; Gordon Growth Model; Real Options; Long-Run Growth; Dynamic Programming; G31; G32 (search for similar items in EconPapers)
JEL-codes: G1 G2 G3 (search for similar items in EconPapers)
Date: 2015
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DOI: 10.1142/S0219091515500186

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