In financial economics, the dividend discount model (DDM) is a method of valuing the price of a company's capital stock or business value based on the assertion that intrinsic value is determined by the sum of future cash flows from dividend payments to shareholders, discounted back to their present value.
[1][2] The constant-growth form of the DDM is sometimes referred to as the Gordon growth model (GGM), after Myron J. Gordon of the Massachusetts Institute of Technology, the University of Rochester, and the University of Toronto, who published it along with Eli Shapiro in 1956 and made reference to it in 1959.
[3][4] Their work borrowed heavily from the theoretical and mathematical ideas found in John Burr Williams 1938 book "The Theory of Investment Value," which put forth the dividend discount model 18 years before Gordon and Shapiro.
When dividends are assumed to grow at a constant rate, the variables are:
is the constant growth rate in perpetuity expected for the dividends.
is the constant cost of equity capital for that company.
is the value of dividends at the end of the first period.
The model uses the fact that the current value of the dividend payment
, so that The DDM equation can also be understood to state simply that a stock's total return equals the sum of its income and capital gains.
Consider the dividend growth rate in the DDM model as a proxy for the growth of earnings and by extension the stock price and capital gains.
Consider the DDM's cost of equity capital as a proxy for the investor's required total return.
When growth is expected to exceed the cost of equity in the short run, then usually a two-stage DDM is used: Therefore, where
denotes the short-run expected growth rate,
is the period (number of years), over which the short-run growth rate is applied.
Even when g is very close to r, P approaches infinity, so the model becomes meaningless.
b) This equation is also used to estimate the cost of capital by solving for
” stands for expected dividend per share one year from the present time, “g” stands for rate of growth of dividends, and “k” represents the required return rate for the equity investor.
The dividend discount model does not include projected cash flow from the sale of the stock at the end of the investment time horizon.
A related approach, known as a discounted cash flow analysis, can be used to calculate the intrinsic value of a stock including both expected future dividends and the expected sale price at the end of the holding period.
If the intrinsic value exceeds the stock’s current market price, the stock is an attractive investment.