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Multistage Dividend Discount Model – Definition

Multistage Dividend Discount Model Definition

Multistage Dividend Discount Model revolves around the Gordon growth model. It is an equity valuation approach and applies fluctuating rates of growth to the calculation. This model implies that various growth rates are allocated to distinct periods of time. There are several versions of the multistage model such as the two-stage, H, and three-stage models.

A Little More on What is a Multistage Dividend Discount Model

The Gordon growth model calculates the present value of a never-ending series of prospective or future dividends. It is assumed that these dividends grow consistently for an infinite period of time. Considering the stability factor, firms such blue chip firms with consistent growth rates follow this model. Such firms, being well-established, offer dividends to shareholders in a consistent manner.

The multistage dividend discount model implies more complications and follows a practical approach when it comes to identifying the worth of dividend-paying firms which get affected by business cycles, unanticipated and consistent financial problems or incentives. This model carries a varying initial growth rate that is either positive or negative. The initial phase continues to exist for a given period of time, and is accompanied by the consistent growth that continues for an endless period.

The multistage dividend discount model has its own drawbacks. But according to this model, the growth rate from the initial period gets consistent overnight. Because of this, the initial growth rate of H-model is high beforehand, followed by a reduction to a consistent growth rate in a gradual manner. This model works on the assumption that the dividend payout ratio and cost of equity of a firm tend to be constant.

The three-stage model offers a consistent high growth rate initially that continues to last for a given time period. The growth reduces in the second phase until it achieves a stable growth rate. This model is a sheer improvement over the other two models, and is valid for almost every firm.

Equity valuation models are classified into two big categories: absolute or intrinsic valuation method and relative valuation method. Dividend discount models such as the Gordon growth model and multistage dividend discount model come under the absolute valuation category. Other models such as residual income, asset-based models, discounted cash flow approach, etc. get covered under absolute valuation methods too. Relative valuation approaches cover comparable models which include ascertaining ratios such as price-to-earnings ratio, and then making their comparison with the multiples of other organizations.