There are a lot of different methods for valuing stocks and determining a fair price for their shares. One of the oldest methods is the dividend discount model, commonly abbreviated to DDM. It’s a more theoretical model in a lot of ways, but can be helpful once you learn how to use it. Let’s dive right in and learn about this tool.
What is the Dividend Discount Model?
The DDM is a method for valuing stocks based on the theory that a stock’s value can be found by calculating the sum of its future dividends. In essence, the value of the stock is the value of predicted dividends discounted back to the present value.
In theory, this model is very helpful and useful. However, in reality, it has a number of restrictions and requires a lot of estimations and guesses about a company’s future. To use it effectively, you have to make educated guesses at a company’s dividend payment patterns, growth patterns and interest rates in the future. Coming up with solid numbers to plug into the equation can be tricky, and this model will not work if the company does not pay out dividends.
Nevertheless, it is a valuable tool. Why? It encourages investors to think about potential outcomes and reevaluate their assumptions about potential growth. However, using the DDM must be done carefully and using the best possible estimates.
How do You Calculate the Dividend Discount Model?
So, how do you use the dividend discount model? Here’s one of the most common variations of the DDM, the Gordon Growth Model:
Price = (Next Year’s Estimated Dividend) ÷ (Company’s Cost of Equity Capital – Estimated Future Dividend Growth Rate)
Price = D ÷ (r – g)
A few quick notes:
– “r” can also be the required rate of return for the stock
– If no growth information or estimated dividend for the next year is available, you can assume constant growth or numbers consistent with historical data. Of course, this may not be entirely accurate.
Because the dividend discount model can only show you the value of a stock based on dividends, it’s important to take it as one of many ways to calculate the value. It’s unwise to assume that the DDM is the best or only way to determine the value of a stock. Instead, use it alongside other methods to help you weigh potential outcomes, growths and more.