When investing, your capital is at risk and you may get back less than invested. Past performance doesn’t guarantee future results.
Dividend Discount Model: Types, Stages, and DDM Formula with Examples
By focusing on the lifeblood of long term investing - dividends - the Dividend Discount Model (DDM) connects a company's future payouts to its worth today. It does this by summing future dividend payouts and discounting them to their present value, comparing the result to the market price.
QUOTE
Do you know the only thing that gives me pleasure? It's to see my dividends coming in.
Big ideas
- The DDM enables investors to check whether a stock is undervalued or overvalued by discounting future dividends and comparing the present value to the current market price.
- If the present value is more than the current market price, the stock is considered undervalued. This can help investors decide whether a stock is worth the price.
- The DDM works well with companies that have an established record of paying out dividends, such as Apple (AAPL), Microsoft (MSFT), Coca-Cola (KO), Johnson & Johnson (JNJ), and others.
What is the Dividend Discount Model (DDM)?
Many companies will issue dividend payouts to stockholders at fixed intervals. If you are not familiar with dividends, make sure to read our guide to getting started with dividends.
The main premise of the DDM is that the fair value of a stock can be calculated by discounting these future dividend payouts. The reason that these payouts have to be discounted is due to the time value of money principle.
The main premise of the DDM is that the fair value of a stock can be calculated by discounting these future dividend payouts. The reason that these payouts have to be discounted is due to the time value of money principle.
This states that a pound today is worth more than a pound in the future, due to the investment potential in the interim period. Expected future dividend payouts are discounted to account for this, arriving at a fair stock valuation.
Here is the key to using it – if the present value is more than the current market price (i.e. the price you can pay is less than its worth) then the stock is undervalued.
Here is the key to using it – if the present value is more than the current market price (i.e. the price you can pay is less than its worth) then the stock is undervalued.
Main components of the Dividend Discount Model
There are three main components to the Dividend Discount Model. These concepts need to be understood before proceeding further with the DDM variations.
- Time value of money – This principle suggests that receiving money today is preferable to receiving the same amount in the future. The logic is simple: money available now can be invested and grow over time – at the very least by the risk-free rate, such as government bond yields. The DDM uses this concept to adjust future dividend payments, recognising that their value diminishes the further into the future they are received.
- Expected dividends – The DDM relies on the assumption that a company will continue to pay dividends in the future. Many large, established companies, particularly in sectors like consumer goods, healthcare, and utilities, have long-standing track records of reliable dividend payments. For income-focused investors, these dividends can be a major draw, especially when combined with dividend reinvestment programmes that help grow returns over time.
- Discounting factor – Also referred to as the discounting factor, this is the rate used to bring future cash flows back to their present value. It typically reflects the investor’s required rate of return and includes adjustments for both the time value of money and the risk associated with the investment. Choosing an appropriate discount rate is crucial, as it directly impacts the outcome of the valuation.
DDM formula
- P₀ – The present value or current fair price of the stock, based on expected future dividends.
- Dₜ – The dividend expected at time t, where t represents a future year.
- r – The required rate of return, also known as the discount rate, reflecting the return an investor expects for the risk taken.
- t – The time period, measured in years into the future, at which each dividend is received.
The first step in the DDM formula is to understand the time value of money formula, where future sums of money can be discounted at a given rate, for a present value.
The discounting of future cash flows has applicability in other formulas, aside from the DDM, and is an essential financial concept.
The actual Dividend Discount Model formula is expressed as the expected dividend per share, divided by the minimum rate of return minus the dividend growth rate.
It works particularly well with Real Estate Investment Trusts (REITS) because such vehicles are required to distribute most of their net income. Energy stocks (oil, gas, etc.) also tend to be suitable for DDM analysis as they have reliable dividends, as part of this business policy.
The discounting of future cash flows has applicability in other formulas, aside from the DDM, and is an essential financial concept.
The actual Dividend Discount Model formula is expressed as the expected dividend per share, divided by the minimum rate of return minus the dividend growth rate.
It works particularly well with Real Estate Investment Trusts (REITS) because such vehicles are required to distribute most of their net income. Energy stocks (oil, gas, etc.) also tend to be suitable for DDM analysis as they have reliable dividends, as part of this business policy.
Variations of the Dividend Discount Model
The DDM helps investors assess a stock's value based on its future dividend payments. Variations of DDM adjust for different growth expectations and investment horizons. These include the Gordon Growth Model (GGM), the single-period model, and the multi-period model, each fitting distinct valuation scenarios.
Gordon Growth Model (GGM)
The GGM is a popular form of the DDM that calculates stock value by assuming a constant growth rate in dividends. It is most applicable for stable companies with predictable dividend increases.
GGM formula
- P₀ – The current fair value or present price of the stock based on expected future dividends.
- D₀ – The most recent dividend paid per share (i.e. the current dividend).
- D₁ – The expected dividend in the next period, typically calculated as D₀ × (1 + g).
- g – The dividend growth rate, representing the annual rate at which dividends are expected to increase.
- r – The required rate of return, or the return an investor expects to earn from the stock. It also acts as the discount rate in the model.
EXAMPLE
Assumptions
• Annual dividend per share: £2.50
• Expected growth rate: 3%(0.03)
• Required rate of return: 8% (0.08)
Calculation
Stock Value = 2.50 × (1 + 0.03) ÷ (0.08 − 0.03) = 2.575 ÷ 0.05 = £51.50
Under the Gordon Growth Model, the company’s estimated stock value is £51.50. If this is more than the current market price, then the company is undervalued.
Past performance is no guarantee of future results. This information is not investment advice. Do your own research. The calculations are hypothetical and intended solely for educational use.
• Annual dividend per share: £2.50
• Expected growth rate: 3%(0.03)
• Required rate of return: 8% (0.08)
Calculation
Stock Value = 2.50 × (1 + 0.03) ÷ (0.08 − 0.03) = 2.575 ÷ 0.05 = £51.50
Under the Gordon Growth Model, the company’s estimated stock value is £51.50. If this is more than the current market price, then the company is undervalued.
Past performance is no guarantee of future results. This information is not investment advice. Do your own research. The calculations are hypothetical and intended solely for educational use.
By dividing expected dividends by the difference between the required rate of return and the growth rate, the model estimates a stock's intrinsic value. This approach is straightforward but works best when a company’s growth and dividends remain steady over time.
Single-period dividend discount model
The single-period DDM calculates a stock's value based on anticipated dividends and price over one period, typically a year. It is used far less often than the GGM. The model adds the expected dividend to the forecasted price at the period’s end and then discounts this sum by the required return.
Single-period DDM formula
- P₀ – The current price or present value of the stock
- D₁ – The expected dividend per share at the end of the period
- P₁ – The expected stock price at the end of the period
- r – The required rate of return
EXAMPLE
Assumptions
• Expected dividend per share: £0.10
• Share price after one year: £1.80 (1.80)
• Rate of return: 10% (0.10)
Calculation
Stock Value = (0.10 + 1.80) ÷ (1 + 0.10) = 1.90 ÷ 1.10 = £1.73
Using the single-period DDM, this company’s stock value is about £1.73.
• Expected dividend per share: £0.10
• Share price after one year: £1.80 (1.80)
• Rate of return: 10% (0.10)
Calculation
Stock Value = (0.10 + 1.80) ÷ (1 + 0.10) = 1.90 ÷ 1.10 = £1.73
Using the single-period DDM, this company’s stock value is about £1.73.
Investors often use this single term DDM model for short-term analysis. It provides a quick valuation but does not account for long-term growth.
Multi-period Dividend Discount Model
The Multi-Period DDM values a stock by projecting dividends across multiple periods, discounting each dividend back to its present value. This model is useful for stocks with dividends that may vary over time, reflecting changes in business cycles or company growth.
Multi-period DDM formula (over 3 years)
- P₀ – The present value or current price of the stock.
- D – The dividend per share expected in each time period.
- r – The required rate of return, reflecting the investor’s expected return for holding the stock.
- n – The final holding period, or the number of years the stock is expected to be held.
- Pₙ – The terminal value, or the expected stock price at the end of the holding period.
EXAMPLE
Assumptions
• Year 1 dividend: £1.50
• Year 2 dividend: £1.55
• Year 3 dividend: £1.60
• Estimated price at the end of Year 3: £45
• Required rate of return: 7% (0.07)
Calculation
P = 1.50 ÷ (1 + 0.07)¹ + 1.55 ÷ (1 + 0.07)² + 1.60 ÷ (1 + 0.07)³ + 45 ÷ (1 + 0.07)³
Breakdown
• Year 1: 1.50 ÷ 1.07 = 1.40
• Year 2: 1.55 ÷ 1.1449 = 1.35
• Year 3: 1.60 ÷ 1.2250 = 1.31
• Terminal value (Year 3): 45 ÷ 1.2250 = £36.73
Adding the values
PV = 1.40 + 1.35 + 1.31 + 36.73 = £40.79
Using the Multi-period DDM, the estimated stock value is approximately £40.79.
• Year 1 dividend: £1.50
• Year 2 dividend: £1.55
• Year 3 dividend: £1.60
• Estimated price at the end of Year 3: £45
• Required rate of return: 7% (0.07)
Calculation
P = 1.50 ÷ (1 + 0.07)¹ + 1.55 ÷ (1 + 0.07)² + 1.60 ÷ (1 + 0.07)³ + 45 ÷ (1 + 0.07)³
Breakdown
• Year 1: 1.50 ÷ 1.07 = 1.40
• Year 2: 1.55 ÷ 1.1449 = 1.35
• Year 3: 1.60 ÷ 1.2250 = 1.31
• Terminal value (Year 3): 45 ÷ 1.2250 = £36.73
Adding the values
PV = 1.40 + 1.35 + 1.31 + 36.73 = £40.79
Using the Multi-period DDM, the estimated stock value is approximately £40.79.
It offers a more detailed analysis compared to single-period models, making it suitable for companies with less predictable dividend patterns and longer-term investment horizons.
DDM vs DCF valuation: What is the difference?
The Dividend Discount Model (DDM) and Discounted Cash Flow (DCF) valuation both estimate a company’s intrinsic value but differ in their focus. DDM values a stock by projecting future dividends and discounting them back to present value, and requires the assumption of predictable dividends.
DCF uses projected free cash flows, typically Free Cash Flow to the Firm (FCFF) or Free Cash Flow to Equity (FCFE) to value a company. This makes DCF more flexible, as it considers all potential cash flows, not just dividends. Both models use a discount rate to account for the time value of money.
Both models use a discount rate, but the discount rate for DDM is typically the cost of equity, while DCF can use either the Cost of Equity (for FCFE) or the WACC (for FCFF). This distinction is important.
While DDM is simpler and works well for established dividend-paying firms, DCF is commonly applied to companies regardless of dividend history, especially for firms with volatile or irregular dividend patterns.
DCF uses projected free cash flows, typically Free Cash Flow to the Firm (FCFF) or Free Cash Flow to Equity (FCFE) to value a company. This makes DCF more flexible, as it considers all potential cash flows, not just dividends. Both models use a discount rate to account for the time value of money.
Both models use a discount rate, but the discount rate for DDM is typically the cost of equity, while DCF can use either the Cost of Equity (for FCFE) or the WACC (for FCFF). This distinction is important.
While DDM is simpler and works well for established dividend-paying firms, DCF is commonly applied to companies regardless of dividend history, especially for firms with volatile or irregular dividend patterns.
Using the DDM for investments
The DDM helps investors assess the value of a stock based on its future dividend payments. As long as the quality of assumptions (growth rate, required rate of return) are good, the DDM offers a straightforward way to determine whether a stock is undervalued or overvalued.
Investors can use it to evaluate dividend-paying companies, especially those with a stable dividend history. This model also helps investors compare different stocks, as they can calculate the intrinsic value and assess potential returns over time.
The DDM works best for companies with consistent dividend growth, allowing investors to make more informed decisions about stock selection and portfolio management.
By focusing on the dividends a company pays, the DDM provides a clear picture of its long-term financial health and sustainability. However, keep in mind that there are many high quality companies that prefer to reinvest funds instead of issuing dividends.
Investors can use it to evaluate dividend-paying companies, especially those with a stable dividend history. This model also helps investors compare different stocks, as they can calculate the intrinsic value and assess potential returns over time.
The DDM works best for companies with consistent dividend growth, allowing investors to make more informed decisions about stock selection and portfolio management.
By focusing on the dividends a company pays, the DDM provides a clear picture of its long-term financial health and sustainability. However, keep in mind that there are many high quality companies that prefer to reinvest funds instead of issuing dividends.
What are the shortcomings of the Dividend Discount Model?
The following are the six major shortcomings associated with the DDM:
- Dividend dependency – The model assumes that the stock’s value is based solely on dividends, making it unsuitable for companies that reinvest profits instead of paying regular dividends.
- Stable growth assumption – It often assumes a constant growth rate, which is unrealistic for companies in fluctuating markets or growth stages.
- Sensitivity to discount rate – Small changes in the discount rate can significantly impact the valuation, reducing reliability.
- Limited to mature companies – DDM is mainly useful for established, dividend-paying firms, making it less applicable to growth companies or industries with high reinvestment needs.
- Ignores non-dividend factors – The DDM does not account for other value drivers, such as acquisitions, brand value, or asset growth.
- Challenges with irregular dividends – For companies with unstable dividends, the model’s assumptions become hard to apply, reducing accuracy.
Recap
The DDM definitely has its uses, particularly for blue chips, REITS (who have to issue dividends due to legal requirements), and commercial banks. Coca-Cola (KO), for instance, has had an annual dividend increase for 63 years. For stable businesses, investors can quickly check whether a stock is under or overvalued.
Still, even when only applied to companies with a strong likelihood of paying dividends, the model is ultimately a projection based on assumptions. After all, dividends are declared at the discretion of company management, and may still be paid even if the business is underperforming.
In sum, the DDM model really applies to businesses with a long history of previous dividend payouts or a high likelihood of dividend payouts to come. But even here, the DDM model is best used with other indicators for a more well-rounded analysis.
Still, even when only applied to companies with a strong likelihood of paying dividends, the model is ultimately a projection based on assumptions. After all, dividends are declared at the discretion of company management, and may still be paid even if the business is underperforming.
In sum, the DDM model really applies to businesses with a long history of previous dividend payouts or a high likelihood of dividend payouts to come. But even here, the DDM model is best used with other indicators for a more well-rounded analysis.
FAQ
Q: What is the 3-step Dividend Discount Model?
The 3-step dividend discount model values a stock by separating future dividend growth into three phases: high growth, moderate growth, and stable growth. Each phase has distinct assumptions about dividend increases. This model is useful for valuing companies with different growth phases, giving a clearer picture of potential long-term value.
Q: How do you calculate the discount rate on the DDM?
The discount rate in the DDM is generally the required rate of return, and the standard way to estimate that is using the Capital Asset Pricing Model (CAPM). CAPM uses the risk-free rate, the stock’s beta, and the equity market premium. This rate reflects the investor’s required return based on the stock's risk and growth prospects.
Q: What is the 25% dividend rule?
The 25% dividend rule is more like an informal strategy used by some investors and suggests reinvesting at least 25% of dividend income back into shares of the stock. Reinvesting this portion can increase overall investment value through compounding, allowing for a larger stock base over time as well as offering some income along the way.
Q: Is the DDM model reliable?
The DDM is often reliable for valuing established companies with stable dividend histories. It is less accurate for growth companies or stocks with irregular dividends. Its reliability depends on the stability of cash flows that allow for assuming a certain dividend growth and the chosen discount rate. For stable dividend stocks, DDM offers a straightforward valuation method.
Q: What are the two-stage vs multi-stage DDM Variations?
Two-stage DDM assumes two growth phases: an initial high-growth period followed by stable growth. Multi-stage DDM allows for multiple growth phases, reflecting more complex growth patterns. Multi-stage models work better for companies experiencing various growth phases, providing more flexibility when valuing companies with changing dividend patterns.
Q: What is the DDM of a REIT valuation?
In REIT valuation, DDM calculates the present value of projected dividends, crucial as REITs distribute most earnings as dividends. Due to this income structure, DDM generally assumes steady or multi-stage growth. This model reflects a REIT’s income potential, making it a popular approach to estimating long-term returns from REIT investments.
