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Say a company is doing an IPO and we expect them to start paying dividends in 5 years?
I understand how we could use the Dividend Discount Model to predict their stock price 4 years from the IPO. But what about the day of the IPO?

How can we use the Dividend Discount Model to value this stock before it pays dividends?

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  • $\begingroup$ By adding up the net present values of the dividends? I am somewhat unsure what your exact question is. $\endgroup$ – Giskard Dec 4 '16 at 19:02
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With what you say and using the DDM we know that

$P_{t=4} = \frac{D_{t=5}(1+g)}{r-g}$

Via the above equation, it is assumed that from year $5$, dividends will annually grow at a $g$ rate and that investors' required rate will be $r$, both forever. Since this calculation is nothing but a simplification (future growth and return rates will a fortiori change, etc...), we will not do more complicated.

Taking into account the share of debt in the capital structure of the company, say $X\%$, we can compute the average cost of capital (average over equity and debt), $r'$, needed to discount $P_{t=4}$. One may have an idea of $X$ or make assumptions about it. It follows that $r'$ is such that

$r' = X\% r_D + (1-X\%) r$

where $r_D$ is the interest rate or the cost of debt (naturally $r_S < r$). Thus the company's IPO may be valued by involving that

$P_{t=0} = \frac{P_{t=4}}{(1+r')^4}$

Finally, as you can see there are many assumptions in this valuation, which is the job of experts, with the most fundamental about $D_{t=5}$.

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  • $\begingroup$ Any question @Daniel64 ? $\endgroup$ – keepAlive 2 days ago
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Typically you use FCF if the company doesn't pay dividends. You can still use dividends starting in year 5 and if you discount the CFs back to year 0, it doesn't matter that you have 0 CF in the first four years, you'll still get the future value of all CFs at year 0.

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