Dividend Discount Model

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Deriving the Dividend Discount Model in the Intermediate Microeconomics Class

Stephen Norman Jonathan Schlaudraff Karianne White Douglas Wills*

May 2012

Abstract This paper shows that the dividend discount model can be derived using the basic intertemporal consumption model that is introduced in a typical intermediate microeconomic course. This result will be of use to instructors who teach microeconomics to finance students in that it demonstrates the value of utility maximization in obtaining one of the first stock valuation models used in basic finance. Keywords: Dividend Discount Model, Intertemporal Consumption, Microeconomics Instruction, Finance Instruction JEL Codes: A22, D90, G12

*Stephen Norman: Assistant Professor, University of Washington - Tacoma, 1900 Commerce Street, Tacoma, WA 98402, Phone: 253-692-4827, Fax: 253-692-4523, Email: normanse@uw.edu. Jonathan Schlaudraff: Student, University of Washington - Tacoma, 1900 Commerce Street, Tacoma, WA 98402, Phone: 253-692-4827, Fax: 253-692-4523, Email: jonathanschlaudraff@gmail.com. Karianne White: Student, University of Washington - Tacoma, 1900 Commerce Street, Tacoma, WA 98402, Phone: 253-692-4827, Fax: 253-692-4523, Email: karimarie84@yahoo.com. Douglas Wills (Corresponding Author): Associate Professor, University of Washington - Tacoma, 1900 Commerce Street, Tacoma, WA 98402, Phone: 253692-5626, Fax: 253-692-4523, Email: dtwills@uw.edu. 1

With the rise in business school enrollments, instructors of intermediate microeconomic theory often find that many of their students are business majors studying finance. As such, it is incumbent upon economists to demonstrate that the core intermediate class is relevant for the understanding of financial theory. This paper argues that financial theory is invariably connected to fundamental economic theory with the link between the two provided by a slight change in terminology and a small addition to the intertemporal consumption model. More specifically, the main contribution of this paper is the demonstration that the dividend discount model can be derived as an outcome of utility maximization. The dividend discount model (DDM) is typically the first stock valuation model introduced to finance students.1 The rationale for the model, along with the constant growth variant, is based on it being an application of the (net) present value concept. In virtually all finance textbooks, both the present value and the dividend discount model are derived intuitively rather than as an outcome of utility maximizing agents. DDM is often presented by viewing future dividends as the sum of cash flows discounted by investor required returns and expected dividend growth. More advanced stock valuation models, such as the capital asset pricing model (CAPM), can also be derived using intermediate theory. Doing so, however, requires the development of both the utility model and how the models handle risk. As such it is difficult to cover the topic adequately over the course of a usual term, considering utility theory tends to be located near the back of textbooks. Given these challenges, the focus of this paper will be on DDM rather than extending these findings to CAPM. The elements of time and utility in the intertemporal consumption model are useful in understanding the derivation of the dividend discount model. Although textbooks typically push

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utility theory to later chapters, the two-period intertemporal consumption model can be introduced as one of the first applications of the two-good indifference curve model. Given that all financial transactions are exchanges across time, the basic intertemporal model can be used to derive this time element in fundamental finance concepts. By converting an interest-paying bond to a dividend paying stock, the model can then be used to derive the dividend discount model. BASIC INTERTEMPORAL CONSUMPTION MODEL The basic intertemporal consumption model is covered in most...
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