Definition: The dividend discount model, or DDM, is a method of valuing a stock on the basis of present value of its expected dividends. The model discounts the expected future dividends to the present value, thereby estimating if a share is overvalued or undervalued.
What Does Dividend Discount Model Mean?
This model holds that the value of a stock is equal to the sum of the net present value or NPV of all the expected future dividends. The DDM comes in several versions based on different assumptions about expected dividend growth.
But, its simplest form is the Gordon Growth Model (GGM), which values a stock on a stable dividend growth assumption. To calculate the fair value of a stock using the Gordon Growth model, we need to know:
- D1 = the expected future value of dividends
- r = expected rate of return
- g = the stable dividend growth rate, in perpetuity
Thus the dividend discount model formula to calculate the fair value of a stock is:
P = D1 / ( r – g )
Let’s look at an example.
Marion analyzes a stock that pays an annualized dividend of $1.20 per share. By looking at the stock’s historical data, Marion finds out that the company has raised its dividendconsecutively for 15 years at an average dividend growth rate of approximately 7% annually. However, due to the ongoing financial crisis, the dividend growth has slowed down over the last five years. Therefore, Marion estimates an average dividend growth rate of 4% annually.
The second step is to estimate r. With a stock that pays an annualized dividend of $1.20 per share and has a stable dividend growth of 4% annually, Marion estimates an expected rate of return of 10%. By discounting the annualized dividend of $1.20 per share at an expected rate of return 10%, she gets an expected dividend of $1.32 per share.
The third step is to calculate the fair value of the stock. So, Marion plugs in the numbers and finds that
P = D1 / (r – g) = $1.32 / (10% – 4%) = $1.32 / 6% = $22
Therefore, the fair value of the stock based on the dividend discount model is $22. If the stock trades above $22, it is overvalued. If the stock trades under $22, it is undervalued.