Multistage Dividend Discount Model

The Gordon (constant) growth dividend discount model is particularly useful for valuing the equity of dividend-paying companies that are insensitive to the business cycle and in a mature growth phase.

On the other hand, multistage models are often used to model rapidly growing companies. The multistage DDM can be extended beyond two stages to however many stages are deemed appropriate. For instance, the valuation of a fairly young company may benefit from a three-stage DDM.

Question

$$\begin{array}{l|lll}
\textbf{Corporation} & \textbf{Sensitivity} & \textbf{3yr Growth} & \textbf{Long-term Growth} \\
& & \textbf{Rate} & \textbf{Rate} \\
\hline
\textbf{A} & \text{Defensive} & 5.0\% & 2.0\% \\
\textbf{B} & \text{Cyclical} & 3.0\% & 3.0\% \\
\textbf{C} & \text{Defensive} & 6.0\% & 6.0\% \\
\end{array}
$$

Which one of the corporations above would most likely be the best fit for a valuation using the Gordon (constant) growth dividend-discount model?

1. Corporation A.
2. Corporation B.
3. Corporation C.

Solution

The correct answer is C.

Due to its insensitivity to the business cycle and a short-term growth rate that corresponds to its long-term growth rate, Corporation C would probably be the most appropriate candidate for valuation using the Gordon (constant) growth DDM.

A multistage model would likely be appropriate for Corporation A due to the significant variance between short-term and long-term growth rates.

A constant growth model valuation may also be appropriate for Corporation B, but accuracy is less likely due to the cyclical nature of its business.