The Dividend Discount Model
- Adam Edwards
- Nov 12, 2024
- 4 min read
The Dividend Discount Model (DDM) is a method used to estimate the value of a company’s stock based on the theory that a stock’s value is equal to the present value of all its expected future dividends. DDM is particularly useful for valuing companies that pay regular, predictable dividends and is based on the principle that dividends represent a tangible return to shareholders.
Formula
The basic formula for DDM is:
Stock Value (P)=Dividend per Share / ( Cost of Equity−Dividend Growth Rate )
Where:
Dividend per Share (D1): The expected dividend per share for the next period.
Cost of Equity (r): The required rate of return for shareholders, often calculated using the Capital Asset Pricing Model (CAPM).
Dividend Growth Rate (g): The expected rate at which dividends will grow over time.
Types of Dividend Discount Models
DDM has different variations depending on assumptions about the growth rate of dividends.
1. Gordon Growth Model (Constant Growth DDM)
Formula: P=D1 / (r−g)
Explanation: This is the most commonly used DDM and assumes that dividends grow at a constant rate (g) indefinitely. It’s best suited for stable, mature companies with a predictable dividend growth rate.
Example: Suppose a company is expected to pay a dividend of £2 per share next year, the cost of equity is 10%, and the dividend growth rate is 4%. The stock price would be calculated as: P=20 / (0.10−0.04) = 20 / 0.06 = £33.33
Interpretation: The model suggests that £33.33 is the fair value of the stock, given its expected future dividends.
2. Zero-Growth DDM
Formula: P = D / r
Explanation: This version assumes dividends do not grow and remain constant indefinitely. It’s used for companies with stable, consistent dividend payments but no growth prospects.
Example: If a company pays an annual dividend of £3 per share and the cost of equity is 8%, the stock price would be: P= 30 / 0.08 = £37.50
Interpretation: With a constant dividend, the fair stock price is £37.50.
3. Multi-Stage DDM
Explanation: This version accounts for different stages of growth. It is used when a company’s dividends are expected to grow at varying rates over different periods, typically starting with a high growth rate that later stabilises.
Formula (Two-Stage Model):
Explanation: This model calculates the present value of dividends over an initial high-growth phase, followed by a terminal value based on a stable growth rate.
Example: Suppose a company is expected to pay dividends of £1, £1.20, and £1.44 in the first three years, followed by constant growth of 5% thereafter. If the cost of equity is 10%, you would calculate the present value of the first three dividends and then apply the Gordon Growth Model for dividends starting from year 4 onward.
How to Interpret DDM
Intrinsic Value: DDM calculates the intrinsic value of a stock based on future dividends. If the model’s price is above the current market price, the stock may be undervalued; if it’s below, the stock may be overvalued.
Sensitivity to Assumptions: DDM is sensitive to the assumed growth rate and cost of equity. Small changes in these inputs can significantly affect the valuation, so accuracy in these assumptions is crucial.
Advantages of DDM
Focuses on Cash Returns: DDM is based on dividends, which are actual cash flows to shareholders. This makes it particularly reliable for valuing companies with stable and predictable dividend policies.
Simple and Intuitive: The model is straightforward, especially the constant-growth version, making it easy to understand and apply.
Long-Term Focus: Since DDM calculates the present value of future dividends, it encourages a long-term view of the stock’s potential returns.
Limitations of DDM
Applicability: DDM is best suited for mature, stable companies with regular dividend payments and is less applicable to high-growth or non-dividend-paying companies (like many tech stocks).
Assumption of Constant Growth: In the constant-growth model, DDM assumes dividends grow at a stable rate indefinitely, which may not be realistic for all companies.
Sensitivity to Assumptions: Small changes in the dividend growth rate or cost of equity can have a large impact on valuation, making it sensitive to estimation errors.
Ignores Capital Gains: DDM only values a stock based on dividend returns and ignores potential capital gains, which are also part of shareholder returns.
DDM vs. Other Valuation Models
DDM vs. Discounted Cash Flow (DCF): DDM focuses on dividends, while DCF looks at all future free cash flows, making DCF more versatile for non-dividend-paying companies.
DDM vs. Price/Earnings (P/E) Ratio: The P/E ratio is a relative valuation metric, while DDM calculates intrinsic value based on future dividends. DDM is more suited for long-term valuation, while P/E is often used for quick comparisons.
DDM vs. CAPM: CAPM calculates the required return (cost of equity) that is often used in DDM as the discount rate.
When to Use DDM
Mature Companies with Stable Dividends: DDM is ideal for valuing established companies that pay consistent and growing dividends, like utility or consumer goods companies.
Stable Economic Conditions: Because DDM relies on constant or predictable dividend growth, it’s best used when the economic outlook is stable, supporting reliable dividend forecasts.
In summary
The Dividend Discount Model (DDM) is a widely used valuation method that calculates a stock’s intrinsic value based on expected future dividends. While DDM works well for stable dividend-paying companies, it’s less suitable for high-growth or non-dividend-paying stocks. DDM’s effectiveness relies heavily on the accuracy of its growth rate and cost of equity assumptions, making it best suited for mature companies with predictable cash flows.