What is the Dividend Discount Model (DDM)?
The Dividend Discount Model (DDM) is a fundamental analysis method used in value investing to estimate the intrinsic value of a company's stock based on its expected future dividends. This financial model assumes that a stock's price is worth the sum of all its future dividend payments, discounted back to their present value. The model is particularly useful for evaluating companies that pay regular dividends.
How DDM Works
The DDM calculates the present value of anticipated dividends by using a formula:
D_1 / (r - g)
Where:
- D1 = expected dividend per share one year from now
- r = required rate of return
- g = growth rate of dividends
Types of DDM
There are several variations of the DDM, including:
- Gordon Growth Model: Assumes a constant growth rate for future dividends.
- Multi-Stage DDM: Accounts for different growth rates in different stages.
Limitations
While powerful, the DDM has limitations. It is primarily suitable for companies with stable dividend policies and may not be applicable for growth stocks that reinvest earnings instead of paying dividends. Additionally, the accuracy of the model is highly dependent on estimating the future growth rate and required return correctly.