what is Dividend Discount Model (DDM)

The Dividend Discount Model (DDM) is a valuation method that estimates the intrinsic value of a company's stock based on the present value of its future dividend payments. Here's how it works: 1. **Basic Premise**: The DDM assumes that the current fair price of a stock equals the sum of all future dividends discounted back to their present value. 2. **Key Components**: - **Dividend Growth Rate**: The model requires an assumption for the rate at which dividends are expected to grow. If the growth rate is constant, it is referred to as the Gordon Growth Model (GGM). - **Discount Rate**: This is the rate at which future dividends are discounted back to their present value. It represents the expected rate of return required by investors. 3. **Calculating Intrinsic Value**: - The formula for the DDM is: Present Value = Future Value / (1 + interest rate\%) where Present Value is the intrinsic value of the stock, Future Value is the value of the dividend at the next period, and interest rate is the expected rate of return. - For example, using an expected dividend of $2.28 at the beginning of 2024, and an expected rate of return of 5% (r = 0.05), an expected dividend growth rate of 2% (g = 0.02), the intrinsic value of the stock would be $76 ($2.28 / (0.05 - 0.02) = $76). 4. **Limitations**: The DDM is less accurate for companies with a lower rate of return compared to the dividend growth rate or for companies that are not expected to maintain dividend payments. 5. **Variations**: The DDM can take several forms, including the Gordon Growth Model, the two-stage model, the three-stage model, and the H-Model, each with different assumptions and complexities. In conclusion, the DDM is a useful tool for investors to estimate the intrinsic value of a company's stock, but it requires careful consideration of the underlying assumptions, especially the dividend growth rate and the discount rate, to ensure the accuracy of the valuation.