The dividend discount model (DDM) is an equity valuation method used to estimate the true or intrinsic value of the stock based on the present value of all future dividend payments. The concept of DDM lies on the financial theory that a stock is fundamentally worth no more than what it will compensate investors in current and future dividends.
The Dividend Discount Formula requires the following components:
- Annual Dividend Per Share – The amount each investor receives as compensation for investing in the company.
- Dividend Growth Rate – Represents the rate at which the dividend is increased from year to year. The dividend growth rate can undergo a stable or constant growth and it can also undergo a combination of different stages:
- A high, aggressive and unsustainable growth rate for a finite period of time.
- A slower and declining growth rate for a finite period of time.
- A stable growth rate for an indefinite period of time (perpetuity).
- Required Rate of Return – Also called “cost of equity”, is the minimum rate of return an investor requires to compensate him for the risk undertaken in investing in the stock. The Capital Asset Pricing Model (CAPM) is often used to determine the rate. The rate calculated should be higher than the dividend growth rate otherwise the stock will have a negative intrinsic value.
The simplest form of the Dividend Discount Model is the Gordon Growth Model, named after the American economist Professor Myron J. Gordon. GGM assumes the company’s business will last indefinitely and the dividend payments increase at a constant rate year to year. If the value calculated is higher than the current trading price, the stock is undervalued and may qualify as a signal to buy. On the other hand, if it is lower the stock is overvalued and may not be a sound investment.
If Company A pays a dividend of $1.50 and expects dividends to grow indefinitely at 5% annually with a required rate of return of 7.5%. What is the intrinsic value of Company A? Incorporating the dividend discount model formula in excel, the intrinsic value of Company A’s stock is $63. If the current trading price of the stock is $85, we can conclude that Company A’s stock is overvalued.
The dividend discount model is not a suitable valuation model for all companies. Regular dividend payments imply that the company has matured in its business and industry. Using DDM to value companies that do not pay dividends such as growth stocks as well as companies that have inconsistent dividend payout (no established dividend payout policy) is not appropriate. In addition, DDM is not applicable to value new companies that are just starting to pay dividends to its shareholders.
Feel free to download the Dividend Discount Model Template which includes the calculation using the Gordon Growth Model here: Dividend Discount Model Calculator.