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Dividend Discount Models

What is a Dividend Discount Model?

A dividend discount model (DDM) is a quantitative model used to value the stock price of a company.

It is based on the assumption that a company's stock price is to be the sum of future dividend payments, which are then discounted back to their present value.

The objectives of the dividend discount model is to generate a company's unbiased stock price without considering market conditions.

Who uses a Dividend Discount Model?

Those who use dividend discount models aim to evaluate whether a stock is worth buying. If the value that's returned from the DDM is superior to its current stock price, this means that a company's price is undervalued, and therefore can be bought.

What are the complexities of a Dividend Discount Model?

With the model based on future dividends, something which can be difficult to estimate, the DDM may be considered complex.

Future dividends are based on assumptions made from previous dividend payments.

The formula for a DDM is as follows:

Value of Stock = Expected Dividend per share / (Cost of Capital Equity - Dividend Growth Rate)

also represented as: Value of Stock = D/(r-g)

What are the different variations of the Dividend Discount Model?

There exist a number of different forms of the DDM, some of which include:

  • Zero Growth Dividend Discount Model: This type of dividend model presumes that dividend will not change in value. Hence the stock price will be:

Annual Dividends / Required Rate of Rate

  • Constant-Growth Rate Dividend Discount Model: Also known as the Gordon Growth Model, this type of quantitative analysis presumes dividend growth year on year. This can be calculated by the following formula:

Value stock = D0 (1+ g) / (K6 - g) = D1 / (K6 - g)

  • Variable-Growth Rate Dividend Discount Model: This is a more realistic model, compared to other variations of the DDM. It presumes that growth rates will be different each year, and commonly states that there will be three stages to growth;

-Initial strong rate of growth -Slight plateau, and subsequent slower growth -Sustainable, more consistent growth rates

What are the advantages of the Dividend Discount Model?

Advantages of the DDM for assessing whether a stock is ready for purchase include:

-Easy to understand, as it is one of the most common ways to calculate the price of shares.

-Consistent, as dividends are regularly paid with cash, businesses tend to align payments with business fundamentals

-Implies mature business, paying regular dividends normally suggests that a company is at a less volatile, mature stage.

What are the disadvantages of the Dividend Discount Model?

-The DDM is unable to calculate stock prices of high growth, less mature companies

-Assumptions are sensitive and thus can make valuation unpredictable

If you wish to learn more about Dividend Discount Models, please visit the following links:

Investopedia description of the DDM

Examples and variations of the model

Advantages and disadvantages of the DDM

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