What is the Dividend Discount Model?
The Dividend Discount Model (DDM) is a valuation method used to determine the intrinsic value of a stock based on the present value of its expected future dividends. It is particularly relevant in the context of value investing, where investors seek undervalued stocks that promise higher returns.
Key Components
- Dividends: Regular payments made by a company to its shareholders, reflecting profits.
- Discount Rate: The required rate of return used to discount future cash flows back to present value.
- Growth Rate: The expected rate at which dividends are anticipated to grow over time.
Formula
The basic formula for the DDM is:
P = D / (r - g)
- P: Price of the stock
- D: Expected annual dividend next year
- r: Discount rate (required return)
- g: Growth rate of dividends
Applications and Limitations
Investors use the DDM to identify undervalued stocks by comparing the model’s intrinsic value to the market price. However, it has limitations, such as its reliance on consistent dividend payments and growth rates, making it less effective for companies that do not pay dividends or have unpredictable dividend policies.