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Portfolio Theory and Quantitative Investment / Market Efficiency, Behavioral Finance, and Equity Valuation

Equity Valuation: Dividend Discount and DCF Models

The EMH tells you whether prices quickly reflect information. Valuation models tell you what the price should be — the fundamental economic value against which the market price can be compared. Without a valuation model, you cannot distinguish a mispriced stock from one whose apparently high or low price is justified by its cash flows.
Every practitioner at a fundamental equity fund, and every quant using fundamental factors, ultimately relies on the logic of discounted cash flow: a share of stock is worth the present value of what it will generate for shareholders. The dividend discount model (DDM) makes this precise. Its main complexity is not the discounting — it is specifying how dividends will grow, and for how long, before the firm reaches a steady state.

This note develops the DDM from the general framework through three growth-period specifications (one-, two-, and three-period models), discusses the cross-sectional regression (P/E regression) approach as an alternative, and identifies the practical pitfalls of both methods.

Learning objectives. By the end of this note you should be able to:
  • derive the general DDM as the present value of all future dividends;
  • state and apply the Gordon growth model (P0=D1/(k−g)P_0 = D_1/(k - g)), and derive g=b⋅rg = b \cdot r;
  • value a stock under the two-period and three-period growth models, given the inputs;
  • explain what a cross-sectional P/E regression measures and state three reasons it may fail as a stock-picking tool;
  • connect the DDM to the implied rate of return and to the price/earnings ratio.

In this lesson

    1. The fundamental valuation principle
    1. The constant growth model (Gordon growth model)
    1. Two-period growth model
    1. Three-period growth model
    1. Cross-sectional P/E regression
    1. From DDM to alpha signals

Before you start

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