Understanding the Dividend Discount Model: Formula, Examples, and Pitfalls

What Is the Dividend Discount Model (DDM)?

The dividend discount model (DDM) is used to predict a company’s stock price based on the theory that its present-day price is worth the sum of all of its future dividend payments when discounted back to their present value.

The DDM is a quantitative method that helps to identify overvalued or undervalued stocks and attempts to calculate a stock’s fair value irrespective of prevailing market conditions.

The dividend discount model connects a company’s future dividends, expected returns, and stock price by asserting that the intrinsic value of its stock is the present value of all its expected future dividends. Higher dividend growth or a lower required rate of return will raise the stock price, while a higher required rate of return will lower it.

The dividend growth rate and the required rate of return are two shortcomings of the DDM, because of its sensitivity to these inputs. Even minuscule changes in these inputs can have a big effect on the stock value calculation.

Read on to learn about dividend discount model formulas, such as the Gordon growth model, as well as variations and examples.

How the Dividend Discount Model Works

A company produces goods or offers services to earn profits. The cash flow earned from such business activities determines its profit, which gets reflected in the company’s stock prices.

Companies pay dividends to stockholders, typically sourced from business profits. The DDM is built on the idea that a company’s value is the present worth of all its future dividends.

If the value determined by the dividend discount model is higher than the current trading price of shares, then the stock is undervalued and qualifies for a buy, and vice versa. Investors use the DDM to discount predicted dividends back to present value. They compare DDM values to market prices to make buy or sell decisions.

Importance of the Time Value of Money in DDM

Imagine that you gave $100 to your friend as an interest-free loan. After some time, you go to them to collect your loaned money. Your friend gives you two options:

1. Take your $100 now
2. Take your $100 after a year

Most individuals will opt for the first choice. Taking the money now will allow you to deposit it in a bank. If the bank pays a nominal interest, say 5%, then your money will grow to $105 after a year. It will be better than the second option, where you get $100 from your friend after a year. Mathematically,

$\begin{aligned}&\textbf{Future Value}\\&\qquad\mathbf{=}\textbf{Present Value }\mathbf{^*(1+}\textbf{interest rate}\mathbf{\%)}\\&\hspace{2.65in}(\textit{for one year})\end{aligned}$​Future Value=Present Value ∗(1+interest rate%)(for one year)​

The above example indicates the time value of money, which can be summarized as “Money’s value is dependent on time.” Looking at it another way, if you know the future value of an asset or a receivable, you can calculate its present worth by using the same interest rate model.

Rearranging the equation above,

$\begin{aligned}&\textbf{Present Value}=\frac{\textbf{Future Value}}{\mathbf{(1+\textbf{interest rate}\%)}}\end{aligned}$​Present Value=(1+interest rate%)Future Value​​

In essence, given any two factors, the third one can be computed.

The dividend discount model uses this principle. It takes the expected value of the cash flows a company will generate in the future and calculates its net present value (NPV) drawn from the concept of the time value of money (TVM).

Essentially, the DDM is built on taking the sum of all future dividends expected to be paid by the company and calculating its present value using a net interest rate factor (also called the discount rate).

Estimating Future Dividends for DDM

Estimating a company’s future dividends can be complex. Analysts might assume or identify trends from past dividends to predict future payouts.

Analysts may assume a fixed dividend growth rate into perpetuity, meaning ongoing identical cash flows indefinitely. For example, if a company has paid a dividend of $1 per share this year and is expected to maintain a 5% growth rate for dividend payment, the next year’s dividend is expected to be $1.05.

Alternatively, if one spots a certain trend—like a company making dividend payments of $2.00, $2.50, $3.00, and $3.50 over the last four years—then an assumption can be made about this year’s payment being $4.00. Such an expected dividend is mathematically represented by (D).

Calculating the Discount Rate in DDM

Shareholders who invest their money in stocks take a risk as their purchased stocks may decline in value. For this risk, they expect a return/compensation. Similar to a landlord renting out their property for rent, the stock investors act as money lenders to the firm and expect a certain rate of return. A firm’s cost of equity capital represents the compensation that the market and investors demand in exchange for owning the asset and bearing the risk of ownership.

This rate of return is represented by (r) and can be estimated using the Capital Asset Pricing Model (CAPM) or the Dividend Growth Model. However, this rate of return can be realized only when an investor sells their shares. The required rate of return can vary due to investor discretion.

Companies that pay dividends do so at a certain annual rate, which is represented by (g). The rate of return minus the dividend growth rate (r – g) represents the effective discounting factor for a company’s dividend. The dividend is paid out and realized by the shareholders.

The dividend growth rate can be estimated by multiplying the return on equity (ROE) by the retention ratio (the latter being the opposite of the dividend payout ratio). Since the dividend is sourced from the earnings generated by the company, ideally, it cannot exceed the earnings.

The rate of return on the overall stock has to be above the rate of growth of dividends for future years. Otherwise, the model may not function properly and lead to results with negative stock prices that are not possible in reality.

The Dividend Discount Model Formula Explained

Based on the expected dividend per share and the net discounting factor, the formula for valuing a stock using the dividend discount model is mathematically represented as:

$\begin{aligned}&\textit{\textbf{Value of Stock}}=\frac{\textit{\textbf{EDPS}}}{\textbf{(\textit{CCE}}-\textbf{\textit{DGR})}}\\&\textbf{where:}\\&EDPS=\text{expected dividend per share}\\&CCE=\text{cost of capital equity}\\&DGR=\text{dividend growth rate}\end{aligned}$​Value of Stock=(CCE−DGR)EDPS​where:EDPS=expected dividend per shareCCE=cost of capital equityDGR=dividend growth rate​

Since the variables used in the formula include the dividend per share and the net discount rate (represented by the required rate of return or cost of equity and the expected rate of dividend growth), the value comes with certain assumptions.

Since dividends, and their growth rate, are key inputs to the formula, the DDM is believed to be applicable only to companies that pay out regular dividends. However, it can still be applied to stocks that do not pay dividends by making assumptions about what dividend they would have paid otherwise.

Exploring Variations of the Dividend Discount Model

The DDM has many variations that differ in complexity.

1. While not accurate for most companies, the simplest iteration of the dividend discount model assumes zero growth in the dividend, in which case the value of the stock is the value of the dividend divided by the expected rate of return.

2. The most common and straightforward calculation of a DDM is known as the Gordon growth model (GGM), which assumes a stable dividend growth rate. It was named in the 1960s after American economist Myron J. Gordon.

This model assumes a stable growth in dividends year after year. To find the price of a dividend-paying stock, the GGM takes into account three variables:

$\begin{aligned}&D = \text{the estimated value of next year’s dividend}\\&r = \text{the company’s cost of capital equity}\\&g = \text{the constant growth rate for dividends, in perpetuity}\end{aligned}$​D=the estimated value of next year’s dividendr=the company’s cost of capital equityg=the constant growth rate for dividends, in perpetuity​

Using these variables, the equation for the GGM is:

$\text{Price per Share}=\frac{D}{r-g}$Price per Share=r−gD​

3. A third variant exists as the supernormal dividend growth model, which takes into account a period of high growth followed by a lower, constant growth period.

During the high growth period, one can take each dividend amount and discount it back to the present period. For the constant growth period, the calculations follow the GGM model. All such calculated factors are summed up to arrive at a stock price.

Applications of the Dividend Discount Model

Assume Company X paid a dividend of $1.80 per share this year. The company expects dividends to grow in perpetuity at 5% per year, and the company’s cost of equity capital is 7%. The $1.80 dividend is the dividend for this year and needs to be adjusted by the growth rate to find D₁, the estimated dividend for next year. This calculation is:

D₁ = D₀ x (1 + g)

D₁ = $1.80 x (1 + 5%)

D₁ = $1.89

Next, using the GGM (variant two above), Company X’s price per share is calculated as follows:

Price per share = D(1) / (r – g)

Price per share = $1.89 / ( 7% – 5%)

Price per share = $94.50

A look at the dividend payment history of leading American retailer Walmart Inc. (WMT) indicates that it paid out annual dividends of $2.08, $2.12, $2.16, $2.20, and $2.24, between 2019 and 2024 in chronological order.

One can see a pattern of a consistent increase of 4 cents in Walmart’s dividend each year, which equals an average growth of about 2%. Assume an investor has a required rate of return of 5%. Using an estimated dividend of $2.28 at the beginning of 2024, the investor would use the dividend discount model to calculate a per-share value of $2.28 / (0.05 – 0.02) = $76.

Limitations of the Dividend Discount Model

The GGM method of DDM is popular but has notable drawbacks.

• The model assumes a constant dividend growth rate in perpetuity. This assumption is generally safe for very mature companies that have an established history of regular dividend payments.

DDM may not suit newer firms with fluctuating or no dividends. More assumptions lower precision. One can still use the DDM on such companies, but with more and more assumptions, the precision decreases.

• The second issue with the DDM is that the output is very sensitive to the inputs. For example, in the Company X example above, if the dividend growth rate drops to 4.5%, the stock price goes to $75.24, over 20% less than $94.50.

• The model also fails when companies have a lower rate of return (r) compared to the dividend growth rate (g). This may happen when a company continues to pay dividends even if it is incurring a loss or relatively lower earnings.

Applying the Dividend Discount Model to Investment Strategies

All DDM variants, especially the GGM, can value a share regardless of current market conditions. The DDM also aids in making direct comparisons of companies, even those in different industries.

Investors who believe in the underlying principle that the present-day intrinsic value of a stock is a representation of its discounted value of future dividend payments can use the DDM to identify overbought or oversold stocks.

If the calculated value is higher than the current market price of a share, it indicates a buying opportunity as the stock is trading below its fair value as determined by the DDM.

However, one should note that the DDM is just one quantitative tool available in the big universe of stock valuation tools. As with any other valuation method used to determine the intrinsic value of a stock, one can use the DDM in addition to the several other commonly followed stock valuation methods.

Since it requires lots of assumptions and predictions, it may not be the sole best way to make investment decisions.

The Bottom Line

The dividend discount model (DDM) assesses the intrinsic value of stocks based on future dividend payments. It’s best used for stocks with a long and stable dividend payment history and is not suitable for companies with little or no dividend history.

The DDM is based on the idea that the stock’s present-day price is worth the sum of all its future dividends when discounted back to its present value. The model relies on assumptions, such as constant dividend growth, which can affect its applicability and precision, especially in volatile markets.

The dividend discount model can help investors pick stocks by helping them to determine whether a stock is overbought or oversold, even when comparing investments across different sectors. However, it should be used with other stock valuation tools and methods to make well-rounded investment decisions. Multiple factors, such as market conditions and company performance, should also be considered before finalizing a decision to buy or sell a stock.