Dividend discount model

The dividend discount model is a way of valuing a company based on the theory that a stock is worth the discounted sum of all of its future dividend payments.^[1] In other words, it is used to evaluate stocks based on the net present value of the future dividends. ^[2]

Dividend discount model is a tool that produces a number based on the data provided. The equation can be written as

$P_0 = \frac{D_1}{r-g},$

where P₀ is the current stock price, D₁ is the expected dividend, r is the required rate of return, and g is the expected growth rate in perpetuity.

This equation is also used to estimate cost of capital by solving for r

$r = \frac{D_1}{P_0} + g.$

From the first equation, one might notice that in the long run, the growth rate cannot exceed the cost of equity; r − g cannot be negative, i.e., r > g. In the short run if g > r, then usually a two stage DDM is used:

$P_0 = \sum_{t=1}^N \frac{D_0 \left( 1+g \right)^t}{\left( 1+r\right)^t} + \frac{P_N}{\left( 1 +r\right)^N}$

Therefore,

$P_0 = \frac{D_0 \left( 1 + g \right)}{r-g} \left[ 1- \frac{\left( 1+g \right)^N}{\left( 1 + r \right)^N} \right] + \frac{D_0 \left( 1 + g \right)^N \left( 1 + g_\infty \right)}{\left( 1 + r \right)^N \left( r - g_\infty \right)},$

where g denotes the short-run expected growth rate, $g_\infty$ denotes the long-run growth rate, and N is the period (number of years), over which the short-run growth rate is applied.

See also

• Gordon model

References

1. ^ Investopedia – Digging Into The Dividend Discount Model
2. ^ Evaluating Stocks using the Dividend Discount Model