4/3/23, 1:25 PM Dividend discount model - Wikipedia

Dividend discount model

In finance and investing, the dividend discount model (DDM) is a method of valuing the price of
a company's stock based on the fact that its stock is worth the sum of all of its future dividend
payments, discounted back to their present value.[1] In other words, DDM is used to value stocks
based on the net present value of the future dividends. The constant-growth form of the DDM is
sometimes referred to as the Gordon growth model (GGM), after Myron J. Gordon of the
Massachusetts Institute of Technology, the University of Rochester, and the University of Toronto,
who published it along with Eli Shapiro in 1956 and made reference to it in 1959.[2][3] Their work
borrowed heavily from the theoretical and mathematical ideas found in John Burr Williams 1938
book "The Theory of Investment Value," which put forth the dividend discount model 18 years before
Gordon and Shapiro.

When dividends are assumed to grow at a constant rate, the variables are: is the current stock price.
is the constant growth rate in perpetuity expected for the dividends. is the constant cost of equity
capital for that company. is the value of dividends at the end of the first period.

Derivation of equation
The model uses the fact that the current value of the dividend payment at (discrete) time

is , and so the current value of all the future dividend payments, which is the current

price , is the sum of the infinite series

This summation can be rewritten as

where

The series in parenthesis is the geometric series with common ratio so it sums to if .
Thus,

https://en.wikipedia.org/wiki/Dividend_discount_model 1/4
4/3/23, 1:25 PM Dividend discount model - Wikipedia

Substituting the value for leads to

which is simplified by multiplying by , so that

Income plus capital gains equals total return

The DDM equation can also be understood to state simply that a stock's total return equals the sum of
its income and capital gains.

is rearranged to give

So the dividend Yield plus the Growth equals Cost of Equity .

Consider the dividend growth rate in the DDM model as a proxy for the growth of earnings and by
extension the stock price and capital gains. Consider the DDM's cost of equity capital as a proxy for
the investor's required total return.[4]

Growth cannot exceed cost of equity

From the first equation, one might notice that cannot be negative. When growth is expected to
exceed the cost of equity in the short run, then usually a two-stage DDM is used:

Therefore,

where denotes the short-run expected growth rate, denotes the long-run growth rate, and is
the period (number of years), over which the short-run growth rate is applied.

https://en.wikipedia.org/wiki/Dividend_discount_model 2/4
4/3/23, 1:25 PM Dividend discount model - Wikipedia

Even when g is very close to r, P approaches infinity, so the model becomes meaningless.

Some properties of the model

a) When the growth g is zero, the dividend is capitalized.

b) This equation is also used to estimate the cost of capital by solving for .

c) which is equivalent to the formula of the Gordon Growth Model (or Yield-plus-growth Model):

where “ ” stands for the present stock value, “ ” stands for expected dividend per share one year
from the present time, “g” stands for rate of growth of dividends, and “k” represents the required
return rate for the equity investor.

Problems with the constant-growth form of the model

The following shortcomings have been noted; see also Discounted cash flow § Shortcomings.

1. The presumption of a steady and perpetual growth rate less than the cost of capital may not be
reasonable.
2. If the stock does not currently pay a dividend, like many growth stocks, more general versions of
the discounted dividend model must be used to value the stock. One common technique is to
assume that the Modigliani-Miller hypothesis of dividend irrelevance is true, and therefore replace
the stock's dividend D with E earnings per share. However, this requires the use of earnings
growth rather than dividend growth, which might be different. This approach is especially useful
for computing the residual value of future periods.
3. The stock price resulting from the Gordon model is sensitive to the growth rate chosen; see
Sustainable growth rate § From a financial perspective

Related methods
The dividend discount model is closely related to both discounted earnings and discounted cashflow
models. In either of the latter two, the value of a company is based on how much money is made by
the company. For example, if a company consistently paid out 50% of earnings as dividends, then the

https://en.wikipedia.org/wiki/Dividend_discount_model 3/4
4/3/23, 1:25 PM Dividend discount model - Wikipedia

discounted dividends would be worth 50% of the discounted earnings. Also, in the dividend discount
model, a company that is not expected to pay dividends ever in the future is worth nothing, as the
owners of the asset ultimately never receive any cash.

References
1. Investopedia – Digging Into The Dividend Discount Model (http://www.investopedia.com/articles/fu
ndamental/04/041404.asp)
2. Gordon, M.J and Eli Shapiro (1956) "Capital Equipment Analysis: The Required Rate of Profit,"
Management Science, 3,(1) (October 1956) 102-110. Reprinted in Management of Corporate
Capital, Glencoe, Ill.: Free Press of, 1959.
3. Gordon, Myron J. (1959). "Dividends, Earnings and Stock Prices". Review of Economics and
Statistics. The MIT Press. 41 (2): 99–105. doi:10.2307/1927792 (https://doi.org/10.2307%2F1927
792). JSTOR 1927792 (https://www.jstor.org/stable/1927792).
4. Spreadsheet for variable inputs to Gordon Model (http://www.retailinvestor.org/perpetuity.xls)

Further reading
Gordon, Myron J. (1962). The Investment, Financing, and Valuation of the Corporation (https://arc
hive.org/details/investmentfinanc0000gord). Homewood, IL: R. D. Irwin.
"Equity Discounted Cash Flow Models" (https://web.archive.org/web/20130612035830/http://page
s.stern.nyu.edu/~adamodar/pdfiles/damodaran2ed/ch5.pdf) (PDF). Archived from the original (htt
p://pages.stern.nyu.edu/~adamodar/pdfiles/damodaran2ed/ch5.pdf) (PDF) on 2013-06-12.

External links
Alternative derivations of the Gordon Model and its place in the context of other DCF-based
shortcuts (https://ssrn.com/abstract=996016)

Retrieved from "https://en.wikipedia.org/w/index.php?title=Dividend_discount_model&oldid=1145166494"

https://en.wikipedia.org/wiki/Dividend_discount_model 4/4