Dividend Discount Model (DDM)

Dividend Discount Model (DDM)

The Dividend Discount Model (DDM) is a valuation method used to estimate the intrinsic value of a company’s stock by discounting its expected future dividends to present value. It is particularly useful for valuing dividend-paying companies with stable dividend policies.

Procedures to Conduct Dividend Discount Model (DDM)

Step 1: Identify the Type of DDM to Use

There are different variations of the DDM, depending on the expected dividend growth pattern:

  1. Constant Growth DDM (Gordon Growth Model)

    • Assumes dividends grow at a constant rate indefinitely.
    • Suitable for mature, stable companies with predictable growth.

  2. Multi-Stage DDM

    • Assumes different dividend growth rates in different periods.
    • Suitable for companies experiencing high initial growth that later stabilizes.

Step 2: Gather Input Variables

Key variables required for the model:

  1. Current Dividend Per Share (D0D_0)

    • The most recent dividend paid.

  2. Expected Dividend Growth Rate (gg)

    • Based on historical dividend growth or company projections.

  3. Required Rate of Return (rr)

    • Often estimated using the Capital Asset Pricing Model (CAPM):
    •  Where:
      • Rf = Risk-free rate (e.g., government bond yield)
      • β  = Stock’s beta (volatility measure)
      • Rm = Expected market return

Step 3: Calculate Intrinsic Value Using the Selected DDM Formula

A. Constant Growth DDM (Gordon Growth Model)

Where:

  • P0 = Intrinsic value of stock
  • D1 = Next year's expected dividend (D1=D0×(1+g))
  • r = Required rate of return
  • g = Dividend growth rate

B. Multi-Stage DDM (Variable Growth)

Used when dividends grow at different rates over time.

  1. Step 1: Project dividends for the high-growth phase.

  1. Step 2: Calculate terminal value at the end of high-growth phase.

  1. Step 3: Discount all future dividends and the terminal value to present.

🔹 Final intrinsic value = Sum of discounted values.

Step 4: Perform Sensitivity Analysis

  • Vary the growth rate (g): Test how changes in dividend growth impact valuation.
  • Adjust the required return (r): Analyze the effect of different risk levels.

Step 5: Validate and Interpret Results

  • Compare with other valuation methods (DCF, Market Multiples).
  • Check if assumptions align with company and industry trends.
  • Consider non-dividend-paying factors (e.g., buybacks, reinvestments).

Key Advantages of DDM

✔ Simple and widely used for stable, dividend-paying companies.
✔ Reflects intrinsic value based on cash flows to investors.
✔ Can be adjusted for different growth scenarios.