The dividend discount model, or DDM, is a method used to value stocks that uses the theory that a stock 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, there is a formula that can help us determine the intrinsic value of the stock.

The dividend discount model

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

A few notes:

  • The price you're calculating is the stock's value based solely off of dividends.
  • If the company has not declared a dividend for next year yet, it's safe to assume that it will grow at a rate consistent with the company's historical dividend growth. This may or may not be a safe assumption, especially if the low-interest environment persists.
  • The cost of equity capital (r), can also be interpreted as the required rate of return. So, if your goal is to produce an annual rate of 10% from your investments, you should use 0.10 here. The price you calculate will be the theoretical price you should pay for the stock that will produce your required rate of return.
  • For stocks with a solid history of dividend growth, it's reasonable to assume that the historical dividend growth rate will continue, unless the company has stated otherwise.
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An example

Let's say that a certain stock is expected to pay a $2.00 dividend next year, and its dividend has historically grown by 4% per year, so it's fair to assume this same growth rate going forward. And we'll say that my desired rate of return is 10%. Using these input values, we can calculate the stock's value (to me) using the dividend discount model as:

Therefore, according to the dividend discount model, I should pay about $33.33 for the stock based on my required rate of return. If the stock were trading for say, $40, an investor using this model may consider the stock to be overvalued, while a price of $25 might make it look like a buying opportunity.

Problems with the dividend discount model

There are a few flaws with the dividend discount model that are worth noting. For one thing, it's a constant-growth model -- in other words, it assumes that the dividend will increase at a constant rate forever. In reality, dividends, even those that increase every year, don't usually do so 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 doesn't allow you to accurately value non-dividend stocks, or growth stocks that pay relatively small dividends.

How investors can use it

Like any valuation method used to determine the intrinsic 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 don't avoid a stock just because the model makes it look expensive. Other metrics, such as return on equity, price-to-earnings ratio, revenue and earnings growth, and the company's dividend payout ratio should also be taken into account, just to name a few.

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