Dividend Discount Model (DDM)

The Dividend Discount Model (DDM) is a valuation method used to determine the price of a company’s Stock based on the theory that its value is the present value of all future dividends. This model assumes that dividends grow at a constant rate over time and is often used for companies that pay regular dividends.

There are several variations of the DDM, including:

  • Gordon Growth Model: Assumes dividends will grow at a constant rate indefinitely.
  • Two-Stage DDM: Allows for an initial period of rapid growth followed by a stable growth phase.
  • Three-Stage DDM: Further refines growth phases to include an initial high growth stage, a transition stage, and a stable growth stage.

The formula for the Gordon Growth Model is:

P = D / (r – g)

Where:

  • P: Price of the Stock
  • D: Expected annual dividend next year
  • r: Required rate of return
  • g: Growth rate of dividends

Example:

Consider a company that is expected to pay a dividend of $5 next year, with a growth rate of 3%, and a required rate of return of 8%. Using the Gordon Growth Model:

P = 5 / (0.08 – 0.03) = 5 / 0.05 = $100

Cases:

  • Stable Dividend Growth: A utility company that consistently pays and grows its dividends.
  • Variable Growth Phases: A tech startup that initially rEINvests profits but plans to pay dividends after reaching a certain Revenue milestone.