A Dynamic Approach to the Dividend Discount Model
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This article derives a dynamic model of the rm with endogenous investment and leverage ratio within the framework of the dividend discount model. Our valuation model incorporates both managerial exibility and long-run growth. We derive closed-form solutions for the optimal policies and rm value, which allow us to compute the value of the real options as well as secular growth in a systematic way. A standard parameterization of the model suggests that the value of the real options can account for more than 8% of the market value of equity, while the present value of growth opportunities can represent more than 10% of share price. We also characterize the type of industries where traditional valuation models lead to considerable underpricing of securities.