Dividend Discount

Lesson

The dividend discount model (DDM) is a valuation method used to determine the value of equity securities by estimating the present value of future dividends. This method assumes that the value of a stock is equal to the sum of all its future dividend payments, discounted back to the present.

Practice Question #1

Which of the following is a key assumption of the dividend discount model?

Terms

Dividend Discount Model (DDM):

A valuation method used to determine the value of equity securities by estimating the present value of future dividends.

Present Value:

The current worth of a future sum of money or stream of cash flows, given a specified rate of return.

Discount Rate:

The interest rate used to determine the present value of future cash flows.

Dividend Growth Rate:

A company's dividend payments' annual percentage growth rate.

Gordon Growth Model:

A simplified version of the DDM that assumes a constant dividend growth rate.

Practice Question #2

What is the primary purpose of using the dividend discount model?

Do Not Confuse With

Net Present Value (NPV):

The difference between the present value of cash inflows and the present value of cash outflows over a period of time.

Practice Question #3

Which of the following factors is NOT used in the dividend discount model?

Historical Example

In the early 2000s, a well-known telecommunications company had a stable dividend growth rate and a high dividend yield. Investors who used the dividend discount model to value the company's stock found that it was undervalued compared to its intrinsic value. As a result, many investors purchased the stock, and its price eventually increased, providing significant returns for those who had used the DDM to make their investment decisions.

Real-World Example

An investor is considering purchasing company shares with a stable dividend growth rate of 5% and a current dividend yield of 3%. Using the dividend discount model, the investor calculates the stock's intrinsic value and compares it to the current market price. If the intrinsic value exceeds the market price, the investor may decide to purchase the stock, expecting its price to increase over time.

Formulas to Remember

Dividend Discount Model (DDM) or Gordon Growth Model (GGM) formula: P = D1 / (r - g) Where: P = the intrinsic value of the stock D1 = the expected annual dividend per share for the next year r = the required rate of return (discount rate) g = the constant growth rate of dividends

Formula Examples

Suppose a stock is expected to pay a dividend of $2.00 per share next year (D1), the required rate of return is 10% (r), and the constant growth rate of dividends is 5% (g). Using the DDM formula, we can calculate the intrinsic value of the stock: P = D1 / (r - g) P = $2.00 / (0.10 - 0.05) P = $2.00 / 0.05 P = $40.00 The intrinsic value of the stock is $40.00.

Pitfalls to Remember

Non-constant growth:

The DDM assumes a constant growth rate of dividends, which may not be accurate for all companies. If a company's dividends are not growing at a constant rate, the model may not provide an accurate valuation.

Negative or unrealistic values:

If the growth rate (g) is greater than or equal to the required rate of return (r), the model will produce a negative or infinite value, which is not a realistic stock price. In such cases, the model is not applicable.