What Is the Dividend Discount Model (DDM)?

The Dividend Discount Model (DDM) is a quantitative method that helps assess the stock price of a company. It is based on the assumption that the present value of a stock is equal to the sum of all the company's future dividends discounted back to their present value. If the calculated value of stock based on DDM is higher than the present traded price of shares, then shares are referred to as undervalued. This model demands detailed assumptions, considering various factors such as the company’s dividend payments, growth rates, and the trend of interest rates. The blog explains "what is Dividend Discount Model (DDM)" by addressing aspects like how it works, how to calculate it, and more in detail. Keep reading!

How Does the Dividend Discount Model Work?

The Dividend Discount Model is an evaluation approach for estimating the value of stocks. It works by considering that the future dividend payment factor determines the value of a given stock.  Dividends are a portion of a company's gains that are distributed to its shareholders. The following is a detailed breakdown of how the Dividend Discount Model (DDM) works. 

• The DDM expresses the value of a stock concerning the discounted value of its future dividends. 
• The model assumes that a stock's fair value equals the sum of all its future dividend payments, adjusted for the time value of money.
• The model puts forward three basic parameters: the current stock price, the expected future dividends, and constant equity capital cost. 
• The discount rate is influenced by the risk associated with the stock. 
• However, the accuracy of this model is greatly affected by the reliability of estimates of growth in dividends and of the forecast of the discount rate.  

Investors often use the DDM with other valuation techniques in order to obtain a more accurate and complete analysis of stock value. Therefore, the DDM approach is known for displaying a fixed and predictable dividend-paying policy. 

How To Calculate Dividend Discount Model (DDM)?

The Dividend Discount Model (DDM) assumes that a stock's intrinsic value is equal to the sum of all its future dividend payments, discounted to their present value. The model can be expressed as: 

DDM = Intrinsic Value = Σ (Present Value of Dividends) + Present Value of Sale Price of the Stock  

In its simplest form, assuming constant dividend growth, the dividend discount model formula is: 

P = D1 / (r - g)

Here:

• P means Current stock price (intrinsic value)
• D1 means next year's dividend value
• r means constant equity capital cost
• g means constant dividend growth rate in perpetuity

By using the dividend discount model formula P = D1 / (r - g), it is easy for an investor to estimate the worth of stock. 

To calculate the dividend discount model, one may consider the following steps: 

Step 1: Forecast The Dividend Pay Out At The End Of The Year (D1):

• Look into the company’s past dividend payments and their trends
• Look into the percentage of income paid out in dividends versus earnings
• Calculate the dividend amount for one year

Step 2: Find the constant equity capital cost (r):

• Calculate using the Capital Asset Pricing Model (CAPM)
• Consider evaluating the risk-free rate and market risk premium
• Adjust for company-specific risk factors 

Step 3: Find the constant dividend growth rate (g):

• Look at the historical records of dividend growth
• Look at the norms in the industry and attributes related to the firm
• Predict a rate of growth that can be maintained over a lengthy period 

Step 4: Use the dividend discount model formula

• Substitute the figures into P = D1 / (r-g)
• Complete the calculation to obtain the stock price and value 

Step 5: Compare the output and analyze

• Understand whether the stock has been overvalued or undervalued by comparing the calculated value of the stock with the share market’s current price
• You may also use multiple scenarios to understand the risk and impact on the valuation 

In this manner, the dividend discount model can be employed by an investor to arrive at the intrinsic value of a stock in accordance with future anticipated dividends. This calculation is important because it aids an investor in assessing the degree of the disparity between the market price for a stock and the calculated value of the stock.

Examples of the Dividend Discount Model (DDM)

Let’s now understand the concept of the Dividend Discount Model (DDM) more clearly with the help of a practical example. 

Consider that a company named ‘XYZ’ has the following data: 

• Current stock price: ₹3,500
• Expected dividend next year (D1): ₹80 per share
• The constant equity capital cost (r): 12%
• Estimated long-term dividend growth rate (g): 8%

As per the dividend discount model formula:

P = D1 ÷ (r - g)

P = ₹80 ÷ (0.12 - 0.08)

P = ₹80 ÷ 0.04

P = ₹2,000 

The DDM has estimated the intrinsic worth of XYZ stocks to be ₹2,000. On this note, having a look at the current market price of  ₹3,500, the model indicates that the company XYZ is worth more than it is. However, investors also need to look at different ways of valuation of the company before making any investment.

Dividend Discount Model (DDM) Variations

The following are the different variations listed in the dividend discount model.

Constant Growth Dividend Discount Model

Each dividend is expected to grow at the same fixed percentage when using this model. The dividend growth is assumed to be at a constant rate. However, there might be an increase in dividend payouts to shareholders every year, as per this model's assumptions. Using this variation, an investor can calculate the current worth of dividends expected to be paid in a stream.

Two-Stage DDM

The two-stage DDM values a firm’s stock price through a model that incorporates an initial phase of greater dividend growth followed by a stage of stable dividend growth. This model variation is also referred to as the multi-stage DDM. In addition, the three-stage DDM is an extension of the two-stage one, and it is characterized by three stages in which the growth rate of the dividend reduces over time.

Variable-Growth Rate DDM Model

This model assumes that dividend growth can be categorized into two or three distinct phases. Here, the first phase may consist of a high growth period, the second phase may consist of an intermediate transition, and the last phase will be a low growth period. This model assists in dealing with problems arising from irregular dividends and anticipates that the firm will pass through different growth phases.  

Zero-Growth Dividend Discount Model

In this model, the assumption is that all dividends paid by the stock will always be of the same amount. This means the model presumes no increase in dividends and there is a constant payment of dividends every year. Furthermore, the stock price would equal annual dividends over the required rate of returns.  

Conclusion
The Dividend Discount Model (DDM) is one of the primary methods that investors use to know the value of a particular stock and how much dividends it can be expected to pay in the future. Other variations such as the constant growth model, two-stage model, and variable growth model provide even more specific analyses for various situations. Currently, many share market apps, have enhanced features and incorporate DDM calculators, making it easier for investors. If one understands the concept of “what is dividend discount model” they might further get a clearer understanding of the right price of the stocks.