A beginner's guide to the dividend discount model (DDM)

One way to think about a share's value is simple: it is worth the dividends it will pay you. The dividend discount model, or DDM, puts this idea into a formula. This page explains how it works, its common versions and when it is useful.

Quick answer

The dividend discount model (DDM) is a valuation method that estimates a share's value as the present value of all the dividends it is expected to pay in the future. Each future dividend is discounted at the investor's required return, usually the cost of equity. The most widely used version, the Gordon growth model, assumes dividends grow at a constant rate forever.

Key takeaways

• DDM values a share from its expected future dividends.
• Dividends are discounted at the cost of equity.
• The Gordon growth model is the basic constant growth version.
• Multi-stage DDMs allow growth to change over time.
• It suits steady dividend payers, not low-payout firms.

What is the dividend discount model?

For an investor who holds a share forever, the only cash received is dividends. The model says the share's value today equals the sum of all those future dividends, each converted into today's money by discounting.

The idea was set out by John Burr Williams in his 1938 book on investment value. It is one of the oldest valuation methods and still widely taught.

The constant growth version

If dividends are expected to grow at a steady rate forever, the formula becomes simple: Value = Next year's dividend / (r minus g), where r is the required return and g is the dividend growth rate. This is known as the Gordon growth model.

For example, if next year's dividend is Rs 12, the required return is 12 percent and dividends are expected to grow 6 percent a year, the value is 12 / 0.06, which is Rs 200 per share. These figures are only for illustration.

Multi-stage versions

In a two-stage model, an analyst forecasts dividends year by year during a high-growth period, then uses the constant growth formula for the years after. Both parts are discounted back and added together.

When does the dividend discount model work well?

It works best for companies with a long record of stable, predictable dividends, such as mature utilities, some large consumer companies and certain public sector firms. Their payout policy makes forecasting dividends easier.

It works poorly for companies that pay little or no dividend, such as fast-growing firms that reinvest most profits. For them, a DCF based on free cash flow is usually more suitable.

What are the limits?

The result is very sensitive to the gap between r and g. If growth is close to the required return, the value becomes very large, which is not realistic. Also, dividends are decided by the board and can be cut, so they are not guaranteed.

In short, this model links a share's value to its future dividends. It is a clear and useful framework for stable payers, but it should be used with sensible, cautious assumptions.

Frequently Asked Questions