Multistage Dividend Discount Model

The multistage dividend discount model is an equity valuation model that builds on the Gordon growth model by applying varying growth rates to the calculation. Under the multistage model, changing growth rates are applied to different time periods. Various versions of the multistage model exist including the two-stage, H, and three-stage models.

The Gordon growth model solves for the present value of an infinite series of future dividends. These dividends are assumed to grow at a constant rate in perpetuity. Given the model’s simplicity, it is generally only used for companies with stable growth rates, such as blue chip companies. These companies are well established and consistently pay dividends to their shareholders at a regular pace, given their steady cash flows.

The multistage dividend discount model allows for greater complexity and practicality when valuing the majority of dividend-paying companies that fluctuate with business cycles, as well as constant and unexpected financial difficulties (or successes). The multistage dividend discount model has an unstable initial growth rate and can be either positive or negative. This initial phase lasts for a specified time and is followed by stable growth that lasts forever.

Even this model has its limitations, however; it assumes that the growth rate from the initial phase will become stable overnight. For this reason, the H-model has an initial growth rate that is already high, followed by a decline to a stable growth rate over a more gradual period of time. The model assumes that a company's dividend payout ratio and cost of equity remain constant.

Finally, the three-stage model has an initial phase of stable high growth that lasts for a certain period. In the second phase growth declines linearly until it reaches a final and stable growth rate. This model improves upon both previous models and can be applied to nearly all firms.

Equity valuation models fall into two major categories: absolute or intrinsic valuation methods and relative valuation methods. Dividend discount models (including the Gordon growth model and multi stage dividend discount model) belong to the absolute valuation category, along with the discounted cash flow (DCF) approach, residual income, and asset-based models. Relative valuation approaches include comparables models. These involve calculating multiples or ratios, such as the price-to-earnings or P/E multiple, and comparing them to the multiples of other comparable firms.