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: