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What is the 'Dividend Discount Model - DDM'

The dividend discount model (DDM) is a procedure for valuing the price of a stock by using the predicted dividends and discounting them back to the present value. If the value obtained from the DDM is higher than what the shares are currently trading at, then the stock is undervalued.

Dividend Discount Model (DDM)

BREAKING DOWN 'Dividend Discount Model - DDM'

This procedure has many variations, and it doesn't work for companies that don't pay out dividends. For example, the supernormal dividend growth model takes into account a period of high growth followed by a lower, constant growth period. The principle behind the model is the net present value (NPV) of the cash flows. To get a growth number, one option is to take the return on equity (ROE) and multiply it by the retention ratio (which is the opposite of the payout ratio).

Dividend Discount Model Calculation

The most common and straightforward for of a DDM is known as the Gordon growth model (GGM), which was named in the 1960s after Myron J. Gordon. To find the price of a dividend-paying stock, the GGM takes into account three variables:

D(1) = the estimated value of next year's dividend

r = the company's cost of equity capital

g = the constant growth rate for dividends, in perpetuity

Using these variable, the equation for the GGM is:

Price per share = D(1) / (r - g)

For example, Company X paid a dividend of $1.80 per share this year. The company expects dividends to grow in perpetuity at 5% per year, and the company's cost of equity capital is 7%. The $1.80 divided is the dividend for this year and needs to be adjusted by the growth rate to find D(1), the estimated dividend for next year. This calculation is: D(1) = D(0) x (1 + g) = $1.80 x (1 + 5%) = $1.89.

Next, using the GGM, Company X's price per share is found to be D(1) / (r - g) = $1.89 / ( 7% - 5%) = $94.50.

While this method of DDM is widely used, it has two well-known shortcomings. The model assumes a constant dividend growth rate in perpetuity. This assumption is generally safe for very mature companies, but newer companies have fluctuating dividend growth rates in their beginning years. The second flaw of this DDM is that the output is very sensitive to the inputs. For example, in the Company X example above, if the dividend growth rate is lowered 10% to 4.5%, the resulting stock price is $75.24 (over a 20% reduction in the $94.50 price).

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