What Is Dividend Discount Model

The Dividend Discount Model (DDM) is a valuation approach that determines a stock’s value by considering its expected future dividend payments. It works on the principle that a stock’s worth is equal to the present value of all expected dividends. By applying a discount rate, the model adjusts future payments to reflect today’s value. DDM is especially useful for valuing companies that have a stable record of paying dividends.

The Dividend Discount Model (DDM) is a stock valuation method that calculates the present value of a company by projecting its future dividend payments. It is based on the idea that dividends are the real returns to shareholders and therefore central to determining a stock’s worth. By discounting these future dividends to their current value, the model helps identify whether a stock is appropriately priced. DDM is particularly effective for valuing companies with consistent and stable dividend policies.

The Dividend Discount Model (DDM) is used to estimate a stock’s intrinsic value by linking it directly to future dividend payments. It calculates the present value of the expected dividends using a discount rate, usually the cost of equity. If the calculated value is higher than the market price, the stock may appear undervalued, and vice versa. This approach is particularly effective for analysing companies with consistent dividend histories.

The basic formula for a single-stage DDM is:

P₀ = D₁ / (r – g)

Where:

• P₀ = Current stock price
  

• D₁ = Expected dividend in the next period
  

• r = Discount rate (cost of equity)
  

• g = Dividend growth rate
  

For example, if a company is expected to pay a dividend of ₹10 next year, with a discount rate of 12% and a dividend growth rate of 6%, the stock price will be:

P₀ = 10 / (0.12 – 0.06) = 10 / 0.06 = ₹166.67

The DDM can take different forms depending on dividend patterns:

• Single-Stage DDM: Assumes dividends grow at a constant rate indefinitely.
  

• Two-Stage DDM: Assumes dividends grow at a high rate initially, followed by a stable rate in the long term.
  

• Three-Stage DDM: Assumes varying growth phases—initial high growth, transitional growth, and stable long-term growth.
  

The three-stage model uses:

P₀ = (Σ Dividends during high growth / (1+r)ᵗ) + (Σ Dividends during transition / (1+r)ᵗ) + (Terminal value at stable growth / (1+r)ᵗ)

Where:

• Dividends = Expected dividends in each phase
  

• r = Discount rate
  

• t = Time period
  

• Terminal value = Value of dividends in the stable growth phase
  

This approach is useful for valuing companies that go through multiple growth cycles.

Suppose a company is expected to pay ₹5 as dividend next year, growing at 8% indefinitely, with a discount rate of 12%.

P₀ = 5 × (1 + 0.08) / (0.12 – 0.08) = 5.4 / 0.04 = ₹135

This illustrates how DDM can estimate stock price based on expected dividends and growth.

The benefits of DDM include:

• Provides a clear link between dividends and stock value.
  

• Useful for valuing stable, dividend-paying companies.
  

• Simple to apply with consistent dividend data.
  

• Can be used to estimate stock valuation relative to market price.
  

The drawbacks of DDM include:

• Not suitable for companies that do not pay dividends.
  

• Highly sensitive to growth rate and discount rate assumptions.
  

• Ignores non-dividend factors influencing stock price.
  

• May not capture value in high-growth or reinvestment-heavy companies.
  

The Dividend Discount Model is a fundamental valuation tool that links stock price directly to expected dividends. While it provides clarity for dividend-paying companies, its reliance on assumptions makes it less effective for firms without stable dividend policies.

This valuation method should not be considered for taking any investment decisions. This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.