Dividend Discount Model (DDM)

What is the dividend discount model

The Dividend Discount Model (DDM) is a financial model used for stock valuation based on predicted future dividends. It was developed by Myron J. Gordon in 1956 and is also known as the Gordon Growth Model. In fact, the terms "DDM" and "Gordon Growth Model" are often used interchangeably, especially when referring to the constant growth version of the model. The DDM is a method to value a stock based on the expected future dividends (money that the company pays you). It provides a simple way to determine how much you should pay for a stock if you know what dividends it will bring you and how fast these dividends will increase.

Our calculator implements both the basic Gordon Growth Model (for infinite growth) and an extended version for finite growth periods, both of which are variants of the Dividend Discount Model.

Dividend Discount Model formula

Certainly! Let's imagine you're considering investing in a company that pays dividends. Here are the assumptions:

• Current dividend: The company pays dividends of $2 per share each year.
• Dividend growth: You expect the dividends to grow by 3% each year.
• Required return: You want your investment to yield at least 8% annually.

How it works

1. Expected dividend for next year: $2 × (1 + 0.03) = $2.06
2. We calculate the stock value: Stock value = Expected dividend for next year / (Required return - Dividend growth)
3. Stock value = $2.06 / (0.08 - 0.03) = $41.20

According to the DDM model, the current value of the stock is $41.20. This means that if you paid $41.20 for the stock, you would expect the investment to return in the form of dividends and dividend growth in line with your expectations.

How do I use the DDM Calculator?

To use the DDM Calculator, follow these steps:

1. Enter the current annual dividend per share (D0)
2. Input the expected annual dividend growth rate in percentage (g)
3. Enter the required rate of return in percentage (r)
4. Optionally, you can enter the number of years of growth (for the finite model)
5. Click the "Calculate" button

The calculator will then provide you with an estimated fair value for the stock based on these inputs.

What's the difference between Finite and Infinite Growth in DDM?

The DDM can be applied using either finite or infinite growth models:

Finite Growth:

• Use: When we expect the high dividend growth rate to last only for a limited time.
• Advantages: More realistic for fast-growing companies, accounts for changes in growth rate.
• Disadvantages: Requires estimating the length of the growth period, more complex calculation.

Infinite Growth:

• Use: For stable companies with consistent dividend growth.
• Advantages: Simple calculation, suitable for mature, stable companies.
• Disadvantages: May overvalue stocks with temporarily high growth, assumes constant growth rate forever.

Our calculator can handle both scenarios. It will automatically use the infinite growth model if you don't enter a specific number of years of growth.

What are the formulas used in the DDM Calculator?

The DDM Calculator uses the following formulas:

• For infinite growth: P = D0 * (1 + g) / (r - g)
• For finite growth: P = Σ [D0 * (1 + g)^t / (1 + r)^t], where t is the number of years

Where P is the stock price, D0 is the current dividend, g is the growth rate, and r is the required rate of return. Note that this model assumes that the dividend growth rate is less than the required rate of return.