A new dividend valuation model

G. DAmico
1
,
Drug Sciences Department, G. DAnnunzio University of Chieti-Pescara
via dei Vestini 31, 66013, Chieti, Italy
(e-mail: g.damico@unich.it)
Abstract. In this paper, a new dividend valuation model is proposed. It assumes that the dividend
growth rate follows a semi-Markov chain. A consequence is that prices become duration dependent. The
paper generalize previous contributions dealing with pricing rms on the basis of fundamentals.
Keywords. Fundamental valuation, semi-Markov chain, reward process, dierence equations
1 Introduction
One of the main approaches to calculate the value of a rm is by means of fundamentals.
Fundamentals analysis consists in the forecasting of future cash ows and discount rates from
a stock market and calculate the value of this stream. Usually cash ows are represented by
dividend streams.
Almost all studies in literature impose sucient structure on the dividend growth (and
discount) process to permit computable expression for the present value of future dividends.
The seminal paper by Gordon and Shapiro (1956) consider a constant dividend growth rate. In
the nineties several generalizations of the Gordon and Shapiro paper appeared. Among them we
cite Hurley and Johnson (1994), Yao (1997) and Hurley and Johnson (1998). In these papers the
dividend growth rate is assumed to be described as a sequence of independent and identically
distributed discrete random variables.
A more recent advancement has been proposed by Ghezzi and Piccardi (2003) where it is
assumed that the dividend growth process is a stationary Markov chain.
In this paper we propose a generalization by assuming that the dividend growth rate is a
semi-Markov chain.
The paper is divided in this way: rst, in section 2, we describe in a short way the nancial
problem. Next, in section 3, we expose some of the results of the new model.
2 The dividend valuation model
Let denote by p(k) the stock price and by d(k) the dividend at time k N. Let i be the annual
interest rate and r = (1 + i). The fundamental valuation formula arms that prices p(k) obey
equation
p(k) =
E
(k)
[d(k + 1) + p(k + 1)]
r
. (1)
As it is well known,see for example Samuelson (1973), if we assume that
lim
i+
E
(k)
[p(k + i)]
r
i
= 0, (2)
prices can be expressed by the series
p(k) =
+

i=1
E
(k)
[d(k + i)]
r
i
. (3)
2 DAmico
In the paper by Gordon and Shapiro (1956) it is assumed a constant growth rate of dividends.
In the more recent paper by Ghezzi and Piccardi (2003) it is assumed that dividend satises
the dierence equation
d(k + 1) = g(k + 1)d(k) (4)
where the growth factor {g(k)} is described by a Markov chain.
Our objective is to extend these models by assumiong that {g(k)} is a semi-Markov chain
and to explain the nancial implications of this choice.
3 The semi-Markov stock model
Let us assume that the dividend process obeys equation (4) where {g(k)} is a SMC of kernel
Q(t) and let be B(t) the backward recurrence time process.
Since (g(t), B(t)) is a Markov process the fundamental equation becomes
p(g(k), B(k)) =
E
(g(k),B(k))
[d(k + 1) + p(g(k + 1), B(k + 1)]
r
(5)
This means that the price at time k depends on the value of the dividend growth process at
time k but also on the duration in this state. As a consequence the model produces duration
dependent prices.
The solution to equation (5) , given that {g(k) = a, B(k) = v}, is
p(a, v) =
+

i=1
E
(k,a,v)
[d(k + i)]
r
i
=
+

i=1
_
E
(k,a,v)
[

i
j=1
g(k + j)]
r
i
_
d(k) (6)
where we assumed that lim
i+
=
E
(k,a,v)
[p(Z(k+i),B(k+i)]
r
i
= 0.
How to compute p(a, v)? For simplicity of exposition let us assume that the process {g(k)}
follows a two state SMC. Let denote by b
ij
(t) = Q
ij
(t) Q
ij
(t 1) and H
i
(t) =

kE
Q
ik
(t).
Then dene
g(v) = max
_
g
1
1 H
1
(v + 1)
1 H
1
(v)
+ g
1
b
11
(v + 1)
1 H
1
(v)
+ g
2
b
12
(v + 1)
1 H
1
(v)
,
g
2
1 H
2
(v + 1)
1 H
2
(v)
+ g
2
b
22
(v + 1)
1 H
2
(v)
+ g
1
b
21
(v + 1)
1 H
2
(v)
_
.
(7)
Set g = sup
vN
g(v). The following result holds true:
Proposition 1 Let us assume that g < r. Then:
i) the series p(a, v) =

+
i=1
E
(k,a,v)
[d(k+i)]
r
i
converges
ii) it meets the asymptotic condition
lim
i+
=
E
(k,a,v)
[p(Z(k + i), B(k + i)]
r
i
= 0.
The solution of the fundamental equation given in formula (6) can be expressed as
p(g(k), B(k)) = (g(k), B(k))d(k) =
g(k)
B(k)
d(k).
The functions

g(k)
B(k)
=
p(g(k), B(k))
d(k)
dividend valuation model 3
are price-dividend ratios and they satisfy the following system of rst order linear dierence
equations with variable coecients.
Proposition 2 If g < r, the pair (
1
v
,
2
v
) satises for all v N the following system of dier-
ence equations:
_
_
g
1
_
1H1(v+1)
1H1(v)
_
0
0 g
2
_
1H2(v+1)
1H2(v)
_
_
_

1
v+1

2
v+1
_

_
r 0
0 r
_

1
v

2
v
_
=
_
_
0 (g
1
g
2
)
_
b12(v+1)
1H1(v)
_
(g
2
g
1
)
_
b21(v+1)
1H2(v)
_
0
_
_

_
1
1
_

_
_
g
1
_
b11(v+1)
1H1(v)
_
g
2
_
b12(v+1)
1H1(v)
_
g
1
_
b21(v+1)
1H2(v)
_
g
2
_
b22(v+1)
1H2(v)
_
_
_

1
0

2
0
_

_
g
1
g
2
_
(8)
Proposition (8) arms that dierent price-dividend ratios have to be associated to each state
and duration value of the dividend growth process.
References
Yao, Y. (1997) A trinomial dividend valuation model. Journal of Portfolio Management, (Summer),
99-103.
Hurley, W.J., Johnson, L.D. (1994) A realistic dividend valuation model. Financial Analysts Journal,
(July-August), 50-54.
Hurley, W.J., Johnson, L.D. (1998) Generalized Markov dividend discount model. Journal of Portfolio
Management, (Fall), 27-31.
Ghezzi, L.L., Piccardi, C. (2003) Stock valuation along a Markov chain. Applied Mathematics and
Computation, 141, 385-393.
Gordon, M.J. , Shapiro, E. (1956) Capital investment analysis: the required rate of prot. Management
Science, 3, 102-110.
Samuelson, P.A. (1973) Proof that properly discounted present values of assets vibrate randomly. Bell
Journal of Economics, 4, 369-374.