CFA Level II Exam · Discounted Dividend Valuation

Valuing Non-Dividend-Paying Stocks and Choosing a DDM

Q: Can you use the DDM for a company that pays no dividends?

Yes. You forecast when dividends will begin and discount them, or you use a finite horizon with a terminal value at the end. The terminal value represents what an investor expects to receive when selling the share.

Q: How do I choose which dividend discount model to use?

Match the model to the company's growth pattern. Use Gordon growth for stable mature firms, a two-stage model for high growth then maturity, a three-stage model for growth, transition and maturity, and an H-model for gradually declining growth.

Q: What is a terminal P/E in a finite horizon DDM?

It is the P/E multiple you expect the share to trade at when you sell it at the end of the forecast period. Terminal value equals forecast EPS at that date times the multiple. It is then discounted back to today with the dividends.

Q: What are the main strengths and weaknesses of the DDM?

It is simple and ties value to cash paid to shareholders, which suits minority investors. It is weak when payout is erratic, when the firm pays no dividends, or when value is very sensitive to growth and required return inputs.

Updated 7 October 2026 · Fact-checked

A non-dividend-paying stock can still be valued with a DDM if you forecast when dividends will start, or use a finite horizon with a terminal value such as a terminal P/E. Discount each forecast dividend and the terminal value at the required return, then sum. Choose the DDM that fits the company's growth and payout pattern.

Understand Valuing Non-Dividend-Paying and Spin-off Situations

The dividend discount model says a share is worth the present value of the cash it will pay you. A company that pays nothing today is not worth zero. Investors expect dividends later, or a payout through a sale or liquidation. So the model still works if you forecast when payments begin.

There are two common ways to handle this. First, forecast the date and size of the first dividend, then value the stream from that point. Second, use a finite horizon: forecast dividends for a set number of years, then add an expected sale price at the end, called the terminal value. Terminal value can come from the Gordon growth model or from a multiple such as a terminal P/E: forecast EPS at the horizon and multiply by an expected P/E.

The model you pick must match the company. A Gordon growth model suits a mature firm with stable growth below the required return. A two-stage model suits a firm with a high growth period followed by a stable one. A three-stage model suits a firm with growth, transition and maturity phases. An H-model approximates a gradual decline in growth. For a firm with no dividends yet, use a model with a start date for payments, or a finite horizon with a terminal value.

The DDM has strengths and limits. It is most useful when dividends reflect earnings power and the firm has a clear payout policy. It is weaker when payout is arbitrary, when the firm is in distress, or when most value comes from the terminal value. A small change in growth or required return can move value a lot, so sensitivity matters.

When you read an item set, find: the required return, the dividend start date and size, the growth rates and phases, and the terminal assumption. Check whether the firm is a control or minority-investor case, because dividends suit minority views while free cash flow suits control views.

Key formulas to remember

Finite horizon DDM: V₀ = Σ [Dₜ ÷ (1 + r)ᵗ] for t = 1 to n + Pₙ ÷ (1 + r)ⁿ; Dₜ may be zero in early years. Pₙ is the terminal value at the end of year n.
Terminal value by Gordon growth: Pₙ = Dₙ₊₁ ÷ (r − g); Valid only if g < r and growth is stable after year n. Use the dividend for year n + 1.
Terminal value by terminal P/E: Pₙ = EPSₙ × (terminal P/E); Use the forecast EPS at the horizon and a justified or comparable P/E.
Justified forward P/E from DDM: P₀ ÷ E₁ = (D₁ ÷ E₁) ÷ (r − g) = payout ratio ÷ (r − g); Links the P/E multiple to payout, required return and growth. Assumes constant growth.
Two-stage DDM (Gordon terminal): V₀ = Σ [D₀(1 + gₛ)ᵗ ÷ (1 + r)ᵗ] for t = 1 to n + [Dₙ₊₁ ÷ (r − gₗ)] ÷ (1 + r)ⁿ, where Dₙ₊₁ = D₀(1 + gₛ)ⁿ(1 + gₗ); gₛ is short-term growth, gₗ is long-term growth, and gₗ < r. Dₙ₊₁ is the first dividend of the long-term stage: grow D₀ at gₛ for n years, then once at gₗ. The terminal value is Dₙ₊₁ ÷ (r − gₗ), measured at the end of year n.
Sustainable growth rate: g = b × ROE, where b = 1 − payout ratio; Use b as retention rate. Useful for estimating long-run growth.

How to solve Valuing Non-Dividend-Paying and Spin-off Situations questions

Use this method on any item set about non-dividend payers or model choice.

1Read the vignette for the company's stage: growth, payout history, and whether dividends are expected to start.
2Choose the model: Gordon for stable mature firms, two- or three-stage for changing growth, H-model for fading growth, finite horizon for a firm with no current dividend.
3List the inputs: required return r, dividend start year, dividend amounts or payout ratio, EPS forecasts, growth rates, and any terminal P/E.
4Build the dividend forecast year by year, showing zeros for years before payments start.
5Compute the terminal value at the horizon using Gordon growth or EPS × terminal P/E. Check that g < r.
6Discount every dividend and the terminal value to today at r, then add them.
7Sanity check: terminal value share of total, and whether the result suits the stated assumptions.
8Answer the exact question, such as value, implied P/E, or which model is most appropriate.

Quickest way: Table-free discounting with a terminal P/E

When to use it: When the vignette gives a few years of dividends or none, plus an EPS forecast and a terminal P/E.

Compute terminal value first: EPS at horizon × P/E.
Discount it with (1 + r)ⁿ using your calculator power key.
Discount each dividend separately, skipping zero years.
Add the pieces and compare with the answer options.
If options differ widely, check the terminal piece first since it is usually the largest.

Common mistakes in Valuing Non-Dividend-Paying and Spin-off Situations

Treating a firm that pays no dividend as worth zero under the DDM.
Students read the model as needing a current dividend.
Fix: Forecast when dividends start, or use a finite horizon with a terminal value based on expected sale price.
Using Dₙ instead of Dₙ₊₁ in the Gordon terminal value.
The formula looks like it uses the last dividend.
Fix: Terminal value at year n uses the next dividend. In a two-stage model, Dₙ₊₁ = D₀(1 + gₛ)ⁿ(1 + gₗ), not Dₙ and not Dₙ × (1 + gₛ).
Discounting the terminal value by n − 1 periods.
Confusion over when the terminal value is measured.
Fix: Pₙ is at the end of year n, so divide by (1 + r)ⁿ.
Applying Gordon growth when g ≥ r.
A high short-term growth rate is used for the terminal stage.
Fix: Use a multistage model so only the stable, lower growth rate is in the perpetuity.
Picking a model by company size instead of growth pattern.
Students memorise labels rather than assumptions.
Fix: Match the model to growth: stable means Gordon, one change means two-stage, gradual fade means H-model.
Ignoring that terminal P/E is circular if based on the same DDM assumptions.
The multiple seems independent.
Fix: Note that a terminal P/E should come from comparable firms or a justified P/E, and check it for consistency.

Worked examples

Example 1

Vignette: Nova Systems pays no dividend. An analyst expects no dividend in years 1 and 2, a dividend of $2.00 in year 3, and $2.40 in year 4. At the end of year 4 she expects the share to sell at 14 times year 4 EPS of $4.00. The required return is 10%. What is the value of the share today? (Use dividends at year end; round to the nearest cent.)

Show the solution

Terminal value P₄ = 14 × 4.00 = $56.00.
PV of year 3 dividend = 2.00 ÷ 1.10³ = 2.00 ÷ 1.3310 = $1.50.
PV of year 4 dividend = 2.40 ÷ 1.10⁴ = 2.40 ÷ 1.4641 = $1.64.
PV of terminal value = 56.00 ÷ 1.4641 = $38.25.
Sum = 1.50 + 1.64 + 38.25 = $41.39.

Answer: About $41.39 per share. Roughly 92% of value comes from the terminal P/E, so the multiple matters most.

Example 2

Vignette: Brightwell Utilities is mature, with a stable payout and growth expected to stay at 3% indefinitely. Required return is 8%. Last year's dividend was $1.50, and the payout ratio is 60%. Q1: Which model is most appropriate? Q2: What is the value? Q3: What is the justified forward P/E?

Show the solution

Q1: Stable growth below the required return and a steady payout suit the Gordon growth model.
Q2: D₁ = 1.50 × 1.03 = $1.545. V₀ = 1.545 ÷ (0.08 − 0.03) = 1.545 ÷ 0.05 = $30.90.
Q3: Justified forward P/E = payout ÷ (r − g) = 0.60 ÷ 0.05 = 12.0.

Answer: Q1: Gordon growth model. Q2: $30.90. Q3: 12.0 times forward earnings.

Exam tips

In a vignette, circle the dividend start year, the horizon, and the terminal assumption before calculating.
If a firm has no dividends, expect a finite-horizon or delayed-dividend setup, and check for a terminal P/E or terminal growth rate.
For model-choice questions, match the growth pattern in the vignette to the model, and name the assumption that fails for the alternatives.
Watch for a terminal value that dominates total value, since examiners use this to test your view of DDM sensitivity.
Keep r and g in the same units and use the next-period dividend in any perpetuity.

Valuing Non-Dividend-Paying and Spin-off Situations: frequently asked questions

Can you use the DDM for a company that pays no dividends?

Yes. You forecast when dividends will begin and discount them, or you use a finite horizon with a terminal value at the end. The terminal value represents what an investor expects to receive when selling the share.

How do I choose which dividend discount model to use?

Match the model to the company's growth pattern. Use Gordon growth for stable mature firms, a two-stage model for high growth then maturity, a three-stage model for growth, transition and maturity, and an H-model for gradually declining growth.

What is a terminal P/E in a finite horizon DDM?

It is the P/E multiple you expect the share to trade at when you sell it at the end of the forecast period. Terminal value equals forecast EPS at that date times the multiple. It is then discounted back to today with the dividends.

What are the main strengths and weaknesses of the DDM?

It is simple and ties value to cash paid to shareholders, which suits minority investors. It is weak when payout is erratic, when the firm pays no dividends, or when value is very sensitive to growth and required return inputs.