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Chapter 12: Dividend discount model

P

Phani Vasantarao

Member
For the dividend discount model, why do we discount with the required rate of return, rather than some kind of risk-free rate of return?
 
Hi - if we are trying to decide what price we would be prepared to pay for a particular equity, we would value it using our required rate of return for that equity.

This basically equals the risk-free (nominal) rate of return plus a risk premium that reflects whatever level of risk we believe there to be within that particular stock.

If we valued it using just a risk-free rate, with no allowance for risk, the value would be relatively high. We would basically be ignoring the risk that the actual future dividends turn out to be different from those that we are valuing in our expected dividend projection.
 
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