CFA Level II Exam · Discounted Dividend Valuation

Dividend Discount Model Basics for CFA Level II

Q: What is the dividend discount model formula?

Value today equals the sum of each expected dividend divided by (1 + r) raised to its year, where r is the required return on equity. With a finite holding period, add the expected terminal price discounted at the same rate.

Q: What is the difference between DDM and FCFE valuation?

DDM discounts dividends actually expected to be paid. FCFE discounts the cash available to shareholders after reinvestment and net borrowing, whether or not it is paid out. FCFE is often preferred when dividends are low or do not track the firm's capacity to pay.

Q: Which discount rate do I use in the DDM?

Use the required return on equity, often estimated with CAPM. Do not use WACC, because that rate applies to cash flows available to all capital providers.

Q: Can DDM value a company that pays no dividends?

Yes, in principle, because dividends are expected eventually, or the firm is sold. In practice, the forecasts are hard, so analysts often switch to FCFE or other models.

Updated 7 October 2026 · Fact-checked

The dividend discount model (DDM) says a share's intrinsic value is the present value of all expected future dividends, discounted at the required return on equity. Forecast dividends and any terminal sale price, pick the cost of equity, discount each cash flow, and add them up.

Understand Dividend Discount Model Basics

A share is a claim on cash the company will pay you. If you hold it forever, the only cash you receive is dividends. So the value today is what those dividends are worth today.

The dividend discount model turns this into arithmetic. You forecast each dividend, then discount it at the required return on equity (r), the return investors demand for bearing the stock's risk. Higher risk means a higher r and a lower value.

If you plan to sell after n years, the sale price is itself the present value of dividends after year n. So valuing with a finite holding period and a terminal price gives the same value as valuing all dividends to infinity, provided the terminal price is consistent with the model.

DDM is not the only way to value equity. Free cash flow to equity (FCFE) discounts the cash available to shareholders after reinvestment and debt flows, whether or not it is paid out. DDM fits best when the firm pays dividends, the dividends are stable and tied to earnings, and you take a minority view. FCFE fits better when payout is low or unrelated to capacity to pay, or when you take a control perspective. Other approaches include multiples and residual income.

In a Level II item set, you must read the vignette, find the dividends, growth and required return, and choose or apply the right model. The required return may need to be built first, for example with CAPM.

Key formulas to remember

General DDM (infinite horizon): V₀ = Σ [Dₜ ÷ (1 + r)ᵗ], t = 1 to ∞; V₀ is intrinsic value today, Dₜ is the expected dividend in year t, r is the required return on equity.
Finite holding period: V₀ = Σ [Dₜ ÷ (1 + r)ᵗ] for t = 1 to n + Vₙ ÷ (1 + r)ⁿ; Vₙ is the expected share price at the end of year n. It must be the value of dividends after year n.
Required return from CAPM: r = Rf + β × (Rm − Rf); Use when the vignette gives the risk-free rate, beta and equity risk premium.
Dividend growth rate: g = (Dₜ ÷ Dₜ₋₁) − 1; Dividend for next year: D₁ = D₀ × (1 + g).
Implied value comparison: If V₀ > market price, undervalued; if V₀ < price, overvalued; Compare intrinsic value with the current market price.

How to solve Dividend Discount Model Basics questions

Use this order for any DDM basics question in an item set.

1Identify the cash flow being asked about: dividends (DDM) or free cash flow to equity (FCFE).
2Find the dividend forecasts in the exhibit and check which year each belongs to (D₀ is paid already, D₁ is next).
3Find or compute the required return r. If only CAPM inputs are given, calculate r first.
4Decide the horizon: infinite, or a finite holding period with a terminal price Vₙ.
5Discount each cash flow by (1 + r)ᵗ using its correct year, including the terminal value at year n.
6Add the present values to get V₀.
7Compare V₀ with the market price and state the conclusion (undervalued, fairly valued or overvalued).
8Check the answer is sensible: a higher r must give a lower value.

Quickest way: Discount-and-add with a calculator check

When to use it: Use for short explicit forecasts of 2 to 4 years with a given terminal price.

Write the cash flows on a timeline: D₁, D₂, ..., Dₙ + Vₙ.
Use the calculator cash flow worksheet: enter the flows and r as I, then compute NPV.
Sanity check: the value should be below the sum of undiscounted cash flows.
Pick the option that matches; eliminate options that ignore the terminal price or use D₀ instead of D₁.

Common mistakes in Dividend Discount Model Basics

Discounting the terminal price at the wrong year or leaving it out.
Students treat the sale price as separate from the dividends.
Fix: Add Vₙ to Dₙ in year n and discount both by (1 + r)ⁿ.
Using D₀ as if it were next year's dividend.
The vignette quotes the dividend just paid and the student plugs it in directly.
Fix: Check the timing. If a growth rate is given with D₀, compute D₁ = D₀ × (1 + g) first.
Using the wrong discount rate, such as WACC or the bond yield, for dividends.
Several rates appear in the exhibit.
Fix: Dividends and FCFE belong to shareholders, so discount at the cost of equity.
Assuming DDM and FCFE always give the same value.
Both are equity cash flow models.
Fix: They differ when FCFE is not fully paid out. Choose by payout policy and the perspective taken.
Rounding r or interim discount factors too early.
Wanting to save calculator steps.
Fix: Keep full precision and round only the final answer.

Worked examples

Example 1

A company is expected to pay dividends of ₹10 in Year 1, ₹12 in Year 2 and ₹14 in Year 3. An analyst expects to sell the share at ₹200 at the end of Year 3. The required return on equity is 10%. (1) What is the intrinsic value? (2) The market price is ₹185. What is the conclusion? (3) If the required return rose to 12%, would value rise or fall?

Show the solution

Timeline: Year 1 = 10, Year 2 = 12, Year 3 = 14 + 200 = 214.
PV of Year 1: 10 ÷ 1.10 = 9.0909.
PV of Year 2: 12 ÷ 1.21 = 9.9174.
PV of Year 3: 214 ÷ 1.331 = 160.7814.
Sum: 9.0909 + 9.9174 + 160.7814 = 179.7897, about ₹179.79.
Compare: 179.79 < 185, so the share is overvalued.
At a higher required return, every present value falls, so the value would fall.

Answer: (1) About ₹179.79. (2) Overvalued, since intrinsic value is below the ₹185 price. (3) Value would fall.

Example 2

An analyst values a stock with CAPM. The risk-free rate is 4%, the equity risk premium is 5% and beta is 1.2. The stock just paid a dividend of ₹5. Dividends are expected to be ₹5.50 in Year 1 and ₹6.05 in Year 2, and the Year 2 ending price is expected to be ₹80. (1) What is the required return? (2) What is the value? (3) What is the Year 2 dividend growth rate?

Show the solution

Required return: r = 4% + 1.2 × 5% = 4% + 6% = 10%.
PV of Year 1 dividend: 5.50 ÷ 1.10 = 5.0000.
Year 2 cash flow: 6.05 + 80 = 86.05.
PV of Year 2: 86.05 ÷ 1.21 = 71.1157.
Value: 5.0000 + 71.1157 = 76.1157, about ₹76.12.
Growth in Year 2: 6.05 ÷ 5.50 − 1 = 0.10, or 10%.

Answer: (1) 10%. (2) About ₹76.12. (3) 10%.

Exam tips

Read the exhibit carefully for which dividend is D₀ and which is D₁. Timing errors are the most common trap.
When a question asks which model suits a company, link the answer to the facts: stable, earnings-linked dividends favour DDM; low or irregular payout favours FCFE.
If the required return is not given, look for CAPM inputs or a build-up and compute it before discounting.
Use the calculator cash flow worksheet for multi-year forecasts to save time and avoid arithmetic slips.
There is no penalty for wrong answers, so always pick an option.

Dividend Discount Model Basics in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Dividend Discount Model Basics: frequently asked questions

What is the dividend discount model formula?

Value today equals the sum of each expected dividend divided by (1 + r) raised to its year, where r is the required return on equity. With a finite holding period, add the expected terminal price discounted at the same rate.

What is the difference between DDM and FCFE valuation?

DDM discounts dividends actually expected to be paid. FCFE discounts the cash available to shareholders after reinvestment and net borrowing, whether or not it is paid out. FCFE is often preferred when dividends are low or do not track the firm's capacity to pay.

Which discount rate do I use in the DDM?

Use the required return on equity, often estimated with CAPM. Do not use WACC, because that rate applies to cash flows available to all capital providers.

Can DDM value a company that pays no dividends?

Yes, in principle, because dividends are expected eventually, or the firm is sold. In practice, the forecasts are hard, so analysts often switch to FCFE or other models.