Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Dividend Discount Model (DDM)

What it is:

The dividend discount model (DDM) is a method for assessing the present value of a stock based on the growth rate of dividends.

How it works (Example):

The dividend discount model (DDM) seeks to estimate the current value of a given stock on the basis of the spread between projected dividend growth and the associated discount rate. The DDM calculates this present value in the following manner:

Present Stock Value = DividendShare / (RDiscount – RDividend Growth)

In the DDM, a present stock value that is higher than a stock's market value indicates that the stock is undervalued and that it is a good time to purchase shares.

To illustrate, suppose stock XYZ declares a dividend of two dollars per share and is currently valued at $125 in the market. Based on the stock's dividend history, a broker determines a dividend growth rate for the stock of five percent per year and a discount rate of seven percent. The present stock value is calculated as follows:

Present Stock Value = $2.00 per share / (0.07 discount – 0.05 dividend growth)
= $2.00 / 0.02
= $100

With a calculated present value of $100 against a market value of $125, stock XYZ is overvalued in this instance and represents an opportunity to sell.

Why it Matters:

The DDM is a tool used by many investors and analysts as an ai to choosing stocks. The greatest disadvantage of the DDM is that it is inapplicable to companies which do not pay dividends.