Dividend Discount Model: Your Guide to Finding Value Stocks

The stock market is one of the most attractive markets, as it is one of the best ways to build wealth, and in doing so dividends are going to help you all along. To learn the mechanics of stock dividends you should know about the Dividend Discount Model(DDM).

The concept behind the Dividend Discount Model or DDM is that shareholders invest in a company to get a return in the form of dividends. Investors evaluate a stock based on the amount of money they expect to receive in the form of dividends in the present and the future. Therefore, to evaluate a stock using the DDM, it is necessary to calculate the total value of the dividend payments that a stock is expected to produce in the coming years.

Dividend Discount Model

What is the Dividend Discount Model?

Before going into the Dividend Discount Model, it's essential to understand the concept of a stock dividend. A stock dividend is a disbursement of a company's profits, wherein the company allocates a specific sum of money to its shareholders.

Generally, when a company distributes its dividends it does so with the authorization of the Board of Directors and on a semi-annual basis.


Read More: Dividends explanation: Earning Passive Income in the UK


Definition of the Dividend Discount Model (DDM)

The Dividend Discount Model (DDM), is a quantitative method used to evaluate the price of a company's shares. This model is based on the assumption that the fair current price of a share is equal to the sum of all the company's future dividends discounted to their present value. In other words, the DDM seeks to determine the intrinsic value of a share based on expectations of future dividends.

It is a model mainly used to evaluate or estimate the cost of a company or business's shares.

This model focuses on the theory that the price of a share is equivalent to the price of the dividends that the company is about to distribute, discounted by its net present value. This measure allows us to identify whether the stock is undervalued or if its value has recently risen on the market.

How to calculate dividend discount model?

The Dividend Discount Model formula that establishes the price of the share is as follows:

dividend discount model

The value of a share at the time of Dividend Discount Model calculation is zero, represented by Vo which is equal to the discount of its future dividends; (Dt) plus the expected price of the share at the time of its sale in year n (Pn) and the discount rate is the expected return rate (r).

Rate of Return

Similarly, the expected return rate is the minimum profitability required of the investment, which is not higher than the risk-free rate plus the premium for the risk associated with that share. Therefore, the greater the perceived risks for the company, the greater the profitability we will have to demand from the investment made.

Want to know which are the best dividend stocks? Read this article.

DDM vs Gordon Growth Model

One of the most important and well-known models in the dividend discount model is the Gordon Growth Model. The Gordon Growth Method states that the value of a share at time 0 (Vo) is equal to the dividend of the next period divided by the expected return rate minus the dividend growth rate.

The Gordon Model and the Dividend Discount Model (DDM) are both methods used to evaluate the present value of a company based on expected future dividends. However, the Gordon Model can be seen as a specific case of the broader Dividend Discount Model. Here are the main differences:

Dividend Discount Model (DDM)Gordon Model (Gordon Growth Model or Dividend Growth Model)
It is a general method for evaluating the price of a stock based on the concept that its current value is equal to the sum of future dividends discounted to the present value.The Gordon Model is a specific version of the DDM that assumes a constant growth of dividends over time. It is also known as the constant dividend growth rate model.
It can accommodate different dividend growth rates (even variable rates over time) and adapts to different business situations.It is particularly useful for evaluating companies in the maturity phase, where dividends are expected to grow at a constant and predictable rate.
It requires the assumption of an appropriate discount rate and estimates of future dividends, which can vary over time.
The formula for the Gordon Model is:
dividend discount model formula

Where P is the stock price, D is the most recent dividend, g is the constant dividend growth rate, and r is the discount rate or required return.

In summary, while the DDM provides a general framework for evaluating stocks based on future dividends, the Gordon model provides a specific formula for calculating the value of a stock assuming a constant growth of dividends. The choice between the two methods depends on the characteristics of the company under consideration and the growth expectations of its dividends.

The problem with DDM forecasts

The DDM requires a considerable amount of speculation, as it involves forecasting future dividends. Even when applied to stable and reliable companies that pay dividends, it is still necessary to make many assumptions about their future performance.

The model is based on the assumption that dividends are constant or grow at a constant rate over time. However, forecasting future dividends is a complex task and subject to many uncertainties. Even for stable companies that pay regular dividends, it can be difficult to predict exactly what the dividend payments will be next year, let alone years down the line.

The problem with high-growth potential stocks

dividend discount model

No DDM model, no matter how complex, can solve the problem of predicting the future cash flows of high-growth potential stocks. Most of the high-growth potential stocks do not pay dividends. On the contrary, they reinvest the profits in the company with the hope of providing shareholders with returns through an increase in the stock price.

If a company's dividend growth rate exceeds the expected return rate, it is not possible to calculate a value as a negative denominator is obtained in the formula. Stocks do not have a negative value. Consider a company with a growing dividend of 20% while the expected return rate is only 5%: in the denominator (r-g), you would get -15% (5% – 20%).

In fact, even if the growth rate does not exceed the expected return rate, high-growth potential stocks, which do not pay dividends, are even more difficult to evaluate using this model. If one hopes to evaluate a high-growth potential stock with the Dividend Discount Model, the evaluation will be based only on conjecture about the company's future profit and political decisions regarding dividends.

Multi-stage Dividend Discount Models

In reality, the performance of most companies varies from quarter to quarter and year to year depending on numerous unpredictable factors. The dividends that companies pay vary based on their profits.

To overcome the problem of irregular dividends, multi-stage models take into account different phases of company growth. Stock analysts build complex forecasting models that reflect many different growth stages to better reflect real prospects. For example, a multi-stage model may predict that a company will have a dividend that will grow by 5% for seven years, 3% for the next three years, and then 2% in perpetuity.

However, this approach also introduces further assumptions into the model. It is not assumed that a dividend will grow at a constant rate, but it is necessary to guess when and by how much a dividend will change over time.

Considerations on the DDM

The Dividend Discount Model is not the only valuation model available and is not suitable for all situations. However, learning how it works encourages reflection on the real value of a stock.

The model forces investors to evaluate various assumptions about growth and prospects. If nothing else, the DDM demonstrates the fundamental principle that the value of a company is given by the sum of its future discounted cash flows. Whether dividends are the correct measure of cash flow is another matter.

The challenge is to make the model as applicable as possible to reality, using the most reliable assumptions available.

Dividend Discount Model: Conclusion

In conclusion, the Dividend Discount Model (DDM) represents a fundamental tool for investors focused on dividends, offering a clear methodology for evaluating the intrinsic value of shares based on future dividend payments. Through the analysis of the payout ratio, investors can determine the sustainability of future dividends, a crucial aspect for those wishing to invest in dividends. Understanding what dividends are and how they contribute to long-term capital growth is essential for identifying the best investment opportunities.

Looking to the future, the dividend calendar for 2024 can provide valuable indications on which companies will distribute dividends and when allowing investors to strategically plan their investments. In addition, stocks with dividends growing for 50 years and dividend aristocrats represent particularly attractive investment categories for those seeking stable and reliable returns over time. These companies have not only demonstrated an exceptional ability to increase payments to their shareholders year after year but also offer a certain peace of mind in terms of financial solidity and reliability.

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FAQ

What is the Dividend Discount Model for?

The Dividend Discount Model (DDM) is used to estimate the current value of a share based on the future dividends expected that the share should generate. This model helps investors determine whether a share is overvalued, undervalued, or correctly valued by the market.

What does DDM mean?

DDM stands for Dividend Discount Model, a method used in finance to evaluate the price of a share through the prediction and discounting of future dividends to their present value.

What does discounting dividends mean?

Discounting dividends means calculating the present value of expected future dividends, and applying a discount rate. This process considers the time value of money, recognizing that a euro today is worth more than a euro received in the future.

What is the formula of the Dividend discount model?

what does ddm mean
The value of a share at the time of Dividend Discount Model calculation is zero, represented by Vo which is equal to the discount of its future dividends; (Dt) plus the expected price of the share at the time of its sale in year n (Pn) and the discount rate is the expected return rate (r).

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