Dividend Discount Model

The Dividend Discount Model (DDM) is a method used to value a company’s stock based on the theory that its price is worth the sum of all future dividend payments discounted back to their present value.

Definition of Dividend Discount Model (DDM)

The DDM evaluates the value of a stock by estimating the expected future dividends and discounting them back to their present value. It is particularly useful for companies that pay regular dividends.

Key Components of the Dividend Discount Model

The main components used in the DDM are:

• Dividends: Regular payments made to shareholders from a company’s profits.
• Discount Rate: The required rate of return by investors, usually determined by using the company’s cost of equity.
• Growth Rate: The anticipated growth rate of future dividends, which usually reflects the company’s potential for growth and profitability.

Types of Dividend Discount Models

There are several variations of the DDM, including:

• Gordon Growth Model: Assumes dividends will grow at a constant rate indefinitely.
• Two-Stage DDM: Models dividends growing at one rate initially and then at a different rate after a specified period.
• Multi-Stage DDM: It allows for multiple growth rates over several periods.

Calculation of the Dividend Discount Model

The Gordon Growth Model, a simple form of the DDM, is calculated using the following formula:

Price = D / (r – g)

Where:

• D: Expected annual dividend in the next year
• r: Discount rate or required rate of return
• g: Growth rate of dividends

Example of Dividend Discount Model Calculation

Consider a company that is expected to pay a dividend of $3 next year, with a required rate of return of 10%, and a constant growth rate of dividends of 5%.

Using the Gordon Growth Model:

• D = $3
• r = 10% or 0.10
• g = 5% or 0.05

Plugging in the values into the DDM formula:

Price = 3 / (0.10 – 0.05) = 3 / 0.05 = $60

This indicates that based on the DDM, the estimated fair value of the stock is $60.

The Dividend Discount Model is a fundamental tool that provides insight into whether a stock is undervalued or overvalued based on its expected future cash flows in the form of dividends.