The Dividend Discount Model (DDM) is a model used to predict the value of a company’s stock. The model bases its calculations on the theory that the value of a stock is equal to all its future dividends discounted to their present value. Investors and shareholders use DDM to evaluate their shares for decision-making purposes.
Usually, if the price of a stock obtained through the model exceeds its market price, the share is considered undervalued. In this case, investors lean towards buying the stock as it means it will reap profits in the future. For shareholders, it means they need to hold on to their stock and sell it in the future. On the other hand, if the price of a stock is lower than its market value, the stock is considered overvalued.
Dividend Discount Model Formula
The formula to calculate the value of a stock using the Dividend Discount Model depends on which variation of the model investors use. The DDM has several variants, such as the Gordon Growth Model or one-period Dividend Discount Model, etc. However, in its simplest form, the formula for DDM is as below.
V0 = D1 / r
In the above formula, ‘V0’ represents the present value of the future dividends of a stock. ‘D1‘ represents the expected dividends from stock after a period. ‘r’ represents the rate of return prevalent in the market.
However, some other variants of DDM also compensate for several periods or take into account any expected growth in the dividends. Based on these factors, investors can also use another variant of the model, as stated above.
Dividend Discount Model Example
To evaluate the price of the stock of a company, ABC Co., investors must first forecast its future dividends. For ABC Co., the expected dividend after one year is $20 per share. Similarly, the required rate of return is 10%. To calculate the value of the stock, investors must use the formula given above.
V0 = D1 / r
V0 = $20 / 10%
V0 = $200
The decision on whether investors buy these stocks depends on its current market value.
Limitations of the Dividend Discount Model
While the Dividend Discount Model is commonly used among investors to evaluate a stock, it also has some limitations. Its limitations include the following.
Depends on dividends
The first limitation of the DDM is that it depends on dividends. Therefore, investors can’t use the model to evaluate stocks of companies that do not pay dividends. Similarly, the model also neglects any expected capital gains from the stocks, which is a possibility.
DDM also requires users to forecast the dividends of a company. For stable companies, it may be straightforward. However, for other companies, forecasting may be inaccurate and result in inconsistent results.
Based on assumptions
The model also uses several assumptions, for example, a rate of return or a growth rate. While these are a crucial part of the calculation, any inaccuracies in them can affect the valuation of a stock. Therefore, these assumptions may hold back some users from using the model.
The Dividend Discount Model is a method used by investors in determining the price of a stock. Based on the results of the model, investors can make decisions. The model has various variants that depend on several factors. Apart from its usage, DDM also has some drawbacks.