What Is the Dividend Discount Model?

What Is the Dividend Discount Model?

By Charles Joseph | Editor, Financial Affairs
Reviewed by Corey Michael | Senior Financial Analyst

The Dividend Discount Model, or DDM, is a method used to value a company’s stock by using predicted dividends and discounting them back to present value. The idea is, if a stock is considered to be undervalued, it’s a good time to buy. If it’s overvalued, it’s a good time to sell. The DDM is based on the premise that a stock’s intrinsic value is equal to the sum of all its future dividend payments when discounted back to their present value. There are two types of dividend discount models – the Gordon growth model and the multi-stage dividend discount model.

Related Questions

1. What is the Gordon growth model?

The Gordon growth model is a simplified version of the Dividend Discount Model which assumes that dividends grow at a constant rate indefinitely. This makes the calculations much simpler. The Gordon growth model is frequently used in finance and economics.

2. What is the multi-stage dividend discount model?

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The multi-stage dividend discount model is a more complex variant of the Dividend Discount Model. It allows for different growth rates at different stages in the company’s life. It’s generally viewed as more accurate as it takes into account changes in the business cycle and the company’s growth phases. However, it requires more information and calculations.

3. What is intrinsic value in stocks?

Intrinsic value in stocks is the perceived actual value of a company or a stock, instead of its current market price. It considers factors like dividends, growth rate, and the discount rate and is used in fundamental analysis to help investors decide whether a company is overvalued or undervalued.

4. How to calculate the present value of dividends?

To calculate the present value of dividends, you’ll need to know the dividend per share that’s expected to be paid in the next period, the growth rate of the dividend, and the required rate of return. The formula for the present value of dividends is: D1 / (r – g) where D1 refers to dividends per share expected for the next year, r is the required rate of return and g is the constant growth rate in dividend.

5. What are the limitations of the Dividend Discount Model?

While the Dividend Discount Model can be a useful tool, it has limitations. For instance, it may not be accurate for companies that don’t pay dividends. It also relies heavily on estimates for future dividends and growth rates which can be inaccurate. In addition, it doesn’t take into account other potential factors that might influence a stock’s price like changes in the overall economy or shifts in market sentiment.