Bonus Alert: Earn 1%, 2%, or 3% on transfers to Robinhood through Oct. 27. FUNDAMENTAL ANALYSIS TOOLS Dividend Discount Model (DDM) Formula, Variations, Examples, and Shortcomings By JAMES CHEN Updated July 20, 2024 Reviewed by GORDON SCOTT Fact checked by J LIMITATIONSBonus Alert: Earn 1%, 2%, or 3% on transfers to Robinhood through Oct. 27. the price of a company's stock based on the theory that its present-day price is worth the sum ofall of its future dividend payments when discounted back to their present value. The DDM attempts to calculate the fair value of a stock irrespective of the prevailing market conditions. It takes into consideration dividend payout factors and the market's expected returns. Ifthe value determined by the DDM is higher than the current trading price of shares, then the stock is undervalued and qualifies for a buy, and vice versa. KEY TAKEAWAYS, * The dividend discount model (DDM) is a mathematical means of predicting the price of a company's stock. The model is based on the idea that the stock's present-day price is worth the sum of all its future dividends when discounted back to its present value. The purpose of the DDM is to calculate the fair value of a stock, regardless of current market conditions. Investors can use the DDM to help them decide whether to buy or sell stock. If the DDM value is greater th is considered undervalued 2 lower, then the stock is seen “Dividend Discount Model Investopedia / Zoe Hansen Understanding the DDMBonus Alert: Earn 1%, 2%, or 3% on transfers to Robinhood through Oct. 27. in the company’s stock prices. Companies also make dividend payments to stockholders, which usually originate from business profits. The DDM model is based on the theory that the value of a company is the present worth of the sum of all of its future dividend payments. Time Value of Money Imagine that you gave $100 to your friend as an interest-free loan. After some time, you go to them to collect your loaned money. Your friend gives you two options: 1, Take your $100 now 2. Take your $100 after a year Most individuals will opt for the first choice. Taking the money now will allow you to deposit it in a bank. If the bank pays a nominal interest, say 5%, then after a year, your money will grow to $105. It will be better than the second option where you get $100 from your friend after a year. Mathematically, Future Value =Present Value *(1-Bonus Alert: Earn 1%, 2%, or 3% on transfers to Robinhood through Oct. 27. The above example indicates the time value of money, which can be summarized as “Money’s value is dependent on time.” Looking at it another way, if you know the future value of an asset or a receivable, you can calculate its present worth by using the same interest rate model. Rearranging the equation above, Future Value Present Value = —— resent Value ~ (7 + interest rate%) In essence, given any two factors, the third one can be computed. The dividend discount model uses this principle. It takes the expected value of the cash flows a company will generate in the future and calculates its net present value (NPV) drawn from the concept of the time value of money (TVM). fi) Essentially, the DDM is built on taking the sum of all future dividends expected to be paid by the company and calculating its present value using a net interest rate factor (also called discount rate). Expected Dividends Estimating the future dividends of and investors may make certain a: past dividend payment history to One can assume that the compan’ perpetuity, which refers to a const infinite amount of time with no er dividend of $1 per share this year w..~Bonus Alert: Earn 1%, 2%, or 3% on transfers to Robinhood through Oct. 27. assumption can be made about this year’s payment being $4.00. Such an expected dividend is mathematically represented by (D).. Discounting Factor Shareholders who invest their money in stocks take a risk as their purchased stocks may decline in value. For this risk, they expect a return/compensation. Similar to a landlord renting out their property for rent, the stock investors act as money lenders to the firm and expect a certain rate of return. A firm's cost of equity capital represents the compensation the market and investors demand in exchange for owning the asset and bearing the risk of ownership. '3) This rate of return is represented by (r) and can be estimated using the Capital Asset Pricing Model (CAPM) or the Dividend Growth Model. However, this rate of return can be realized only when an investor sells their shares. The required rate of return can vary due to investor discretion. 4 Companies that pay dividends do so at a certain annual rate, which is represented by (g). The rate of return minus the dividend growth rate (r- g) represents the effective discounting factor for a company’s dividend. The dividend is paid out and realized by the shareholders. The dividend growth rate can bee (ROE) by the retention ratio (the le payout ratio). Since the dividend i company, ideally it cannot exceed The rate of return on the overall st dividends for future years. Otherw lead to results with negative stock DDM FormulaBonus Alert: Earn 1%, 2%, or 3% on transfers to Robinhood through Oct. 27. EDPS Value of Stock (ee nap) where: EDPS = expected dividend per share CCE = cost of capital equity DGR = dividend growth rate Since the variables used in the formula include the dividend per share and the net discount rate (represented by the required rate of return or cost of equity and the expected rate of dividend growth), the value comes with certain assumptions. Since dividends, and their growth rate, are key inputs to the formula, the DDM is believed to be applicable only to companies that pay out regular dividends. However, it can still be applied to stocks that do not pay dividends by making assumptions about what dividend they would have paid otherwise. (5) DDM Variations The DDM has many variations that differ in complexity. 1. While not accurate for most corr discount model assumes zero gro’ the stock is the value of the divide 2. The most common and straight Gordon growth model (GGM), whi: was named in the 1960s after Ame This model assumes a stable grow price of a dividend-paying stock, the GGM takes into account three variables:Bonus Alert: Earn 1%, 2%, or 3% on transfers to Robinhood through Oct. 27. g = the constant growth rate for dividends, in perpetuity Using these variables, the equation for the GGM is: Price per Share = 3. A third variant exists as the supernormal dividend growth model, which takes into account a period of high growth followed by a lower, constant growth period. During the high growth period, one can take each dividend amount and discount it back to the present period. For the constant growth period, the calculations follow the GM model. All such calculated factors are summed up to arrive at a stock price. Examples of the DDM ‘Assume Company X paid a dividend of $1.80 per share this year. The company expects dividends to grow in perpetuity at 5% per year, and the company's cost of equity capital is 7%. The $1.80 dividend is the dividend for this year and needs to be adjusted by the growth --t=t- fad the artinnatad ait next year. This calculation is: Dy=Dox(1+8) Dy = $1.80 x (1+ 5%) D, = $1.89 Next, using the GGM (variant two avove), Company as price per snare 1sBonus Alert: Earn 1%, 2%, or 3% on transfers to Robinhood through Oct. 27. Price per share = $1.89 / (7% - 5%) Price per share = $94.50 Alook at the dividend payment history of leading American retailer Walmart Inc. (WMT) indicates that it paid out annual dividends of $2.08, $2.12, $2.16, $2.20, and $2.24, between 2019 and 2024 in chronological order. !7) One can see a pattern of a consistent increase of 4 cents in Walmart's dividend each year, which equals an average growth of about 2%. Assume an investor has a required rate of return of 5%. Using an estimated dividend of $2.28 at the beginning of 2024, the investor would use the dividend discount model to calculate a per-share value of §2.28/ (.05 - .02) = $76. Shortcomings of the DDM While the GGM method of the DDM is widely used, it has well-known shortcomings. + The model assumes a constant dividend growth rate in perpetuity. This assumption is generally safe for very mature companies that have an established history of regular dividend payments However, DDM may not be the bes fluctuating dividend growth rates DDM on such companies, but with decreases. + The second issue with the DDM is inputs. For example, in the Compz rate is lowered by 10% to 4.5%, th than a 20% decrease from the ear!Bonus Alert: Earn 1%, 2%, or 3% on transfers to Robinhood through Oct. 27. pay dividends even if it is incurring a loss or relatively lower earnings. !5! Using the DDM for Investments All DDM variants, especially the GGM, can value a share regardless of current market conditions. The DDM also aids in making direct comparisons of companies, even those in different industries. !*) Investors who believe in the underlying principle that the present-day intrinsic value of a stock is a representation of its discounted value of future dividend payments can use the DDM to identify overbought or oversold stocks. If the calculated value is higher than the current market price of a share, it indicates a buying opportunity as the stock is trading below its fair value as determined by the DDM. However, one should note that the DDM is just one quantitative tool available in the big universe of stock valuation tools. As with any other valuation method used to determine the intrinsic value of a stock, one can use the DDM in addition to the several other commonly followed stock valuation methods. Since it requires lots of assumptions and predictions, it may not be the sole best way to make investment decision: What Are the Types of Di The main types of dividend discot two-stage model, the three-stage How Can the DDM Help Inv The DDM can be used to value a st dividends it pays out in the future market price of the stock. If the market price is lower than the DDM value, it canBonus Alert: Earn 1%, 2%, or 3% on transfers to Robinhood through Oct. 27. dividend on the ex-dividend date. The 25% dividend rule states that if the dividend is 25% or more than the stock's value then the ex-dividend date will be deferred to one business day after the dividend is paid. !°! The Bottom Line The dividend discount model can help investors pick stocks, by helping them to determine whether a stock is overbought or oversold, even when comparing investments across different sectors. The model is best used for stacks with a long dividend history and is not as suitable for ones with a short dividend history or no dividend history at all. As with any investment, a multitude of factors should be evaluated before finalizing a decision to buy or sell a stock. Compete Risk Free with $100,000 in Virtual Cash Put your trading skills to the test with our FREE Stock Simulator. Compete with thousands of Investopedia traders and trade your way to the top! Submit trades ina virtual environment before you start risking your own money. Practice trading strategies so that when you're ready to enter the real market, you've had the practice you need. Try our Stock Simulator today >> ARTICLE SOURCES ¥ Compare Accountsarn 1%, 2%, or 3% on transfers to Robinhood through Oct. 27. 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