Dividend Discount Model

The Dividend Discount Model (DDM) is a widely used approach to value common stocks. Financial theory stats that the value of any securities is worth the present value of all future cash flow the owner will receive. If we assume that stock investor receive all their cash fow in the form of dividend, a DDM will give the intrinsic value for a stock.

A common stock can be tough as the right to receive future dividends. A stock's intrincic value can be defined as the value of all future dividends discounted at the appropriate discount rate. In its simpliest form, the DDM uses, as discount rate, the investor's required rate of return.

Assumptions of the model

• The future value of dividend is know by the investor.
• Dividends are expected to be distributed at the end of each year until infinity.
• Dividends are the only way inversors get money back from the company. This implies that any share buyback would be ignored.

Inputs to the model

To estimate the value of a common share, one must know at least:

• $D_{1}$: the expected dividend to be received in one year;
• $k$: the required rate of return on the investment. There are many methods to estimate this required rate of return, the most common is the Nobel-prize reward Capital Asset Pricing Model;
• $g$: the expected growth rate in dividends.

If no growth in dividends

In the case where the dividend is not expected to growth in the future ($g=0$), then the stock is also known as a perpetuity.

In that case, the price of the stock would be equal to:

$P_{0}={\frac {D}{1+k}}+{\frac {D(1+g)}{(1+k)^{2}}}+{\frac {D(1+g)^{2}}{(1+k)^{3}}}+...={\frac {D}{k}}$.

See Also

Gordon Model