Loading the player...

What is the 'Dividend Discount Model - DDM'

The dividend discount model (DDM) is a procedure for valuing a stock's price by discounting predicted dividends to the present value. If the value obtained from the DDM is higher than the current trading price of shares, then the stock is undervalued.

Dividend Discount Model (DDM)

BREAKING DOWN 'Dividend Discount Model - DDM'

The dividend discount model is based on the idea that the intrinsic value of a stock can be estimated by the expected value of the cash flows it will generate in the future. The driving principle behind the model is the net present value (NPV) of the cash flows, which draws from the concept of the time value of money (TVM).

The DDM is derived from the formula for the present value of a perpetuity. Its variables include the dividend per share, the discount rate (also the required rate of return or cost of equity) and the expected rate of dividend growth. The model, therefore, does not work for companies that don't pay out dividends. While not accurate for most companies, the simplest iteration of the dividend discount model assumes zero growth in the dividend, in which case the value of the stock is the value of the dividend divided by the required rate of return.

The required rate of return can vary due to investor discretion. Meanwhile, the dividend growth rate can be estimated by multiplying the return on equity (ROE) by the retention ratio (the latter being the opposite of the payout ratio).

Dividend Discount Model Variations and Calculation

The DDM has many variations that differ in complexity. The supernormal dividend growth model, for example, takes into account a period of high growth followed by a lower, constant growth period. For more on valuing a stock using this model, see: Valuing a Stock With Supernormal Growth Rates.

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

  • D1 = 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 = D1 / (r - g)

Examples of the DDM With Stable Growth

Assume 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 D1, the estimated dividend for next year. This calculation is: D1 = D0 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.

Now, take for example the annual cash dividends paid out by Walmart Inc. between January 2014 and January 2018: $1.92, $1.96, $2.00, $2.04 and $2.08, in chronological order. Walmart's dividend has increased by $0.04 each year, which equals average growth of about 2%. Assume an investor has a required rate of return of 5%. Using an estimated dividend of $2.12 at the beginning of 2019, the investor would use the dividend discount model to calculate a per-share value of $2.12/(.05 - .02) = $70.67.

Shortcomings of the DDM

While the GGM 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).

RELATED TERMS
  1. Gordon Growth Model

    The Gordon Growth Model is used to determine the intrinsic value ...
  2. Dividend Growth Rate

    The annualized percentage rate of growth that a particular stock's ...
  3. Dividend Rate

    The dividend rate is the total expected dividend payment from ...
  4. Dividend Policy

    Dividend policy structures the dividend payout a company distributes ...
  5. Stock Dividend

    A stock dividend, also known as a scrip dividend, is a dividend ...
  6. Dividend Frequency

    Dividend frequency is how often a dividend is paid by an individual ...
Related Articles
  1. Investing

    Valuing A Stock With Supernormal Dividend Growth Rates

    If these calculations are off, it could drastically change the value of the shares.
  2. Investing

    How Dividends Affect Stock Prices

    Find out how dividends affect the underlying stock's price, the role of market psychology, and how to predict price changes after dividend declarations.
  3. Investing

    Microsoft Is Paying Dividends. Is Its Share Price Undervalued Or Overvalued Based On DDM? (MSFT)

    How can you use the dividend discount model to estimate the value the common stock of Microsoft?
  4. Investing

    AAPL: Apple Dividend Analysis

    Apple's dividend has had healthy growth ever since its 2012 reinstatement, thanks to Apple's continuously rising revenue, earnings and operating cash flow.
  5. Investing

    Is Dividend Investing a Good Strategy?

    Understanding dividends and how they generate steady income for shareholders will help you become a more informed and successful investor.
  6. Investing

    Dividend Growth Likely to Slow in 2017

    Investors who saw dividend increases in the past five years are likely to see them slow this year.
  7. Investing

    4 Ratios to Evaluate Dividend Stocks

    Discover details about fundamental analysis ratios that could help to evaluate dividend paying stocks, and learn how to calculate these ratios.
  8. Investing

    5 Reasons Why Dividends Matter to Investors

    Learn five of the primary reasons why dividends are of significant importance for the overall performance of stock market investments.
RELATED FAQS
  1. What is the difference between yield and dividend?

    Learn how to differentiate between dividend yield and dividend return, and see why dividend yield is the more popular rate ... Read Answer >>
  2. What is the difference between the dividend yield and the dividend payout ratio?

    Learn the differences between a stock's dividend yield and its dividend payout ratio, and learn why the latter might be a ... Read Answer >>
Hot Definitions
  1. Yield Curve

    A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but ...
  2. Portfolio

    A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents, also their mutual, exchange-traded ...
  3. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
  4. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  5. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  6. Current Assets

    Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...
Trading Center