Discounted dividend model (DDM)

Meaning and definition of Discounted Dividend Model

The discounted dividend model (DDM) is a procedure for valuing a stock’s price by using expected dividends and discounting them back to present value. The underlying idea is that if the value obtained from the dividend discount model is greater than the value at which shares are being already traded, the stock is considered to be undervalued. Putting it simple, the discounted dividend model is one of the methods of evaluating a company based on the theory that a stock holds the value equal to the discounted sum of all the prospective dividend payments.

As explained by Investopedia, this procedure features many variations. However, these variations do not work for companies which do not pay out dividends. For instance, one variation is the supernormal dividend growth model which includes a period of high growth followed by a lower and constant growth period. The underlying principle behind this model is the net present value of the cash flows. To obtain a growth number, one good option would be taking the return on equity (ROE) and multiplying it by the retention ratio (which is 1-payout ratio)

Formula for Discounted Dividend Model (DDM)

The general formula used for discounted dividend model is:

Value of Stock = Dividend per share / (Discount rate – Dividend growth rate)

Summary

The discounted dividend model (DDM) is in no way the be-all and end-all for evaluation. In saying this, learning about the discounted dividend model is helpful in encouraging thinking. It insists investors to valuate different assumptions related to growth and future prospects. If nothing else, the discounted dividend model reveals the underlying principle that a company deserves the sum of its prospective discounted cash flows. The main challenge is making the model as germane to the reality as possible. This implies the use of most reliable assumptions on hand.

However, the discounted dividend model is one of the most conservative and oldest methods of evaluating stocks. It is one of the basic components of a financial theory which is essential to be learnt by an introductory finance class. Unluckily, the easy part is the theory. The model demands loads of assumptions related to dividend payments and growth patterns of a company in addition to future interest rates.