The dividend discount model, or DDM, is a method used to value a stock based on the idea that it is worth the sum of all of its future dividends. Using the stock's price, the company's cost of capital, and the value of next year's dividend, investors can determine a stock's value based on the net present value of expected future dividends.

What exactly does all of this mean? In short, if you're buying a stock primarily based on its dividend, the dividend discount model can be a useful tool to determine exactly how much of the stock's price is supported by future dividends. But it's not perfect, because it makes a lot of assumptions that may or may not prove true.

## The dividend discount model

There are several dividend discount models to use, but by far the most common is the Gordon Growth Model, which uses next year's estimated dividend (D), the cost of equity capital (r), and the estimated future dividend growth rate (g).

The formula for the Gordon Growth Model is as follows:

Price = D ÷ (r-g)

So what exactly does the result mean? The price you get at the end is, in essence, a way to value a stock based entirely on expected future dividends. You can then use the price the model arrives at, and determine whether the actual share price meets your requirements.

Some important notes.

• The dividend you use to calculate a price is the expected future payout and expected future dividend growth. This means the model is most useful with companies that have long, consistent dividend records, such as the Dividend Aristocrats.
• If you apply the formula to a company with a limited dividend history, or in an industry exposed to significant risks that could affect a company's ability to maintain its payout, the resulting price you derive from the formula may not prove reliable.

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## An example of the dividend discount model

Let's say that a certain stock is expected to pay a \$1.00 dividend next year, and its dividend has historically grown by 5% per year, so it's fair to assume this same growth rate going forward. And we'll say that the cost of capital based on the expected rate of return is 10%. Using these input values, we can calculate the stock's value (to us) using the dividend discount model:

\$1.00 dividend ÷ (10% cost of capital - 5% dividend growth rate) = \$20

Therefore, according to the dividend discount model, I should pay about \$20 for the stock based on my required rate of return. If the stock is trading for say, \$25, an investor using this model may consider it overvalued, while a price of \$18 might make it look like a buying opportunity.

## Other dividend discount model formulas

The Gordon Growth Model is handy if you're buying a stock to retain for the long term. Two other models can be used to evaluate a dividend stock you may be considering selling in the near term, or if you're looking to determine its value over a shorter period of time than "forever."

These two models are called the one-period dividend discount model and the multiperiod dividend discount modelThey get significantly more complicated, as you will need to estimate future stock prices as well as calculate expected future dividends paid for individual periods.

## Problems with the dividend discount model

There are a few flaws with the dividend discount model that can make it less useful for some stocks.

• First, it's a constant-growth model -- it assumes that the dividend will increase at a constant rate forever. Dividends, even those that increase every year, don't usually increase at a constant rate.
• Second, the equation is extremely sensitive to changes in the input values. Because the difference between the two rates in the denominator is usually quite small, changing the cost of equity or the dividend growth rate by even a fraction of a percentage point can make a big difference in the valuation of the stock.
• Finally, the model can't be used to value nondividend stocks, or growth stocks that pay relatively small dividends.

That's not to say the dividend discount model is useless; on the contrary, it can be helpful in determining if your estimates of value and expectations for companies with reliable dividend histories are reasonable. The main takeaway is that it's a method with a limited scope.

## How investors can use it

Like any valuation method used to determine the value of a stock, the best way to use a dividend discount model is as one piece of the puzzle. In other words, don't buy a stock just because the dividend discount model tells you that it's cheap, and, conversely, don't avoid a stock just because the model makes it look expensive. Other metrics, such as return on equity, price-to-earnings and other financial ratios, revenue and earnings growth, and the company's dividend payout ratio, should also be taken into account, just to name a few.