With the dividend discount model, the formula is share price = dividend of share/(discount rate - dividend growth rate).
I had no idea what discount rate you would use. Would you use cost of equity? Given that stocks are equity.
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Cost of equity
Dividend Discount Model is commonly used to value financial institutions, so considering banks have fundamentally different uses for working capital and debt, you can't use the regular WACC calculation for discount rt b/c debt in theory is considered inventory. Banks make money off of the spread of interest rates, so therefore debt can be considered a product. Since debt isn't used as part of the capital structure, in order to keep apples-to-apples theme, you must use cost of equity as discount rt as well levered free cash flow. Levered free cash flow b/c interest has already been accounted for, so therefore the remaining is only available to equity investors, which is apples-to-apples w/ cost of equity.
Interesting, so its cost of equity but not the WACC cost. Would it just be the typical risk free rate + Beta(risk premium)
Yes, If company outside the U.S., add the country risk factor to that.
You can use CAPM to calculate cost of equity. Expected return on investment = Risk free rate (Rf) + B * (E{market} - Rf), E{market} is the expected return on market. The model assumes that people have the same return on the market for their investments. Also, share price is current year's, but dividend is next year's.
I think you cannot use wacc bc debt is no the same for banks/insurers than for your regular company. that said, I find DDM to be quite interesting, do you guys have any resource I could work with to learn more about it? i know there are some cases on the internet and going through them atm but any other resource would be highly valued
Pm me
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