Dividend Discount model (DDM)
What is covered
The Dividend Discount Model (DDM) is a valuation method used to estimate the intrinsic value of a stock by calculating the present value of all future dividends expected to be paid to shareholders. It is based on the idea that dividends represent the actual cash returns investors receive from owning equity, and therefore form the foundation of a stock’s value. By forecasting dividend payments, applying an appropriate cost of equity, and incorporating assumptions about dividend growth, the DDM provides a structured framework for valuing dividend-paying companies. This model is most commonly applied to mature businesses with stable payout policies and is widely used in equity research, investment analysis, and long-term portfolio management.
What is a Dividend discount model?
Like we said above the process is similar to a discounted cash flow analysis but instead of estimating free cash flow, you estimate dividend payments instead. So, a Dividend Discount Model is a valuation approach used to estimate the intrinsic value of a stock by calculating the present value of the dividends it is expected to pay in the future. The model is based on the idea that dividends are the direct cash returns shareholders receive, and that a stock’s value today reflects the discounted value of those future payments using an appropriate cost of equity. By focusing on shareholder cash flows rather than market sentiment, the DDM offers a structured, cash-flow-driven framework for evaluating equity value over the long term.
"Can you walk me through a precedent transactions model?"
"A Dividend Discount Model values a stock by estimating the present value of all future dividends paid to shareholders. I would start by projecting expected dividends based on the company’s dividend policy, payout ratio, and earnings growth. Next, I’d determine the appropriate discount rate, which is the cost of equity, typically calculated using CAPM.
Depending on the company’s dividend profile, I’d choose the appropriate DDM structure, such as a constant growth model for stable, mature companies or a multi-stage model if dividend growth changes over time. I’d then discount the projected dividends back to today and sum their present values to arrive at the intrinsic equity value per share. The model is most useful for companies with predictable dividend payments and provides a cash-flow-based view of what a stock is worth to shareholders."
Dividend discount
model (DDM)
Gordon Growth Method
One - Period DDM
Multi - period DDM
Formulas
PT 1 - Gordon growth method
One of the most widely used versions is the Gordon Growth Model, which assumes dividends grow at a constant rate indefinitely. Under this model, the value of the stock is calculated using the next period’s expected dividend, the cost of equity (often estimated using CAPM), and the constant growth rate of dividends to infinity. This version works best for established, mature companies with a history of stable dividend increases.
The formula for the Gordon growth method is:
P =
0
D
1
r - g
Where:
-
P0 – The current fair value of a stock
-
D1 – The dividend payment in one period from now
-
r – The estimated cost of equity capital (usually calculated using CAPM)
-
g – The constant growth rate of the company’s dividends into infinity
PT 2 - Single period model
I will preface this by saying this is not a very common variation of the model but it still should be looked into. The single-period Dividend Discount Model is the simplest form of the DDM and is used when an investor plans to hold a stock for a short, defined period. In this model, the stock’s value is calculated as the present value of one expected dividend payment plus the expected selling price of the stock at the end of the holding period. The selling price is often estimated using another valuation method. This approach is most useful for short-term investment horizons and situations where dividend payments and exit value can be reasonably estimated.
The formula for the single period model is:
P =
0
D
1
1 + r
+
V
1
1 + r
Where:
-
P0 – The current stock value
-
D1 – The dividend payment in one period from now
-
V1 – The stock price in one period from now
-
r – The estimated cost of equity capital
PT 3 Multi - period model
The multi period model is more commonly used in the industry and what will be focused on for recruitment and equity analysis. The multi-period Dividend Discount Model extends this framework by valuing a stock as the present value of multiple future dividend payments over several periods. It requires forecasting dividends for each year and discounting each payment back to present value using the cost of equity. This model is more realistic for long-term investors, as it captures changes in dividend levels over time. Multi-period models can also be adapted into multi-stage versions, allowing dividend growth to vary across different phases of a company’s life cycle before reaching a stable growth rate.
The formula for the multi - period growth model is:
P =
0
D
1
(1 + r)
1
+
D
2
(1 + r)
2
+
...
+
D
n
(1 + r)
n
+
V
n
(1 + r)
n
Pt 4 - DDM Example
Imagine you are an equity analyst. Your client asked you to assess whether the firm should buy stock into Shane Corp. The client expects to hold the investment for three years and sell it at the end of the holding period (Would be the end of the third year).
You’ve forecasted that Shane Corp. will pay dividends of $1.75 in the first year, $2.25 in the second year, and $2.75 in the third year. You expect that at the end of the third year, the selling price of the company’s stock will be $95 per share. The estimated cost of capital is 4%. The current stock price is $75 per share.
D = $1.75
1
D = $2.25
2
D = $2.75
3
V = $95
3
1
0
2
3
(1 + 4%)
(1 + 4%)
2
(1 + 4%)
3
P =
0
1
$1.75
(1 + .04)
+
$2.25
(1 + .04)
2
+
$2.75
(1 + .04)
3
+
$95
(1 + .04)
3
= 90.76
The intrinsic value of the company’s stock is $90.76, which is more than its current stock price ($75). Therefore, we can say that the stock is currently undervalued.
Downsides
A downside of the DDM is that the model follows an assumption that the dividends will grow at one constant rate into infinity. This assumption is not ideal for most companies, as fluctuating dividend growth rates or irregular dividend payments can be common depending on the market. Another drawback is the sensitivity of the outputs to the inputs. Finally, the model is not fit for companies with rates of return that are lower than the dividend growth rate.
Summary
Once the dividend forecasts and growth assumptions are established, all future dividend payments are discounted back to present value using the cost of equity, which reflects the return an investor requires for taking on the risk of owning the stock. Summing these present values yields the model’s intrinsic estimate of the stock’s fair value. In models with a long forecasting horizon, a terminal value can also be calculated to capture the value of dividends beyond the explicit forecast period.
The Dividend Discount Model is most appropriate for companies that pay regular, predictable dividends and have relatively stable growth prospects, such as mature consumer goods firms, utilities, or financial institutions with consistent payout policies. Because the model depends heavily on projected dividends and growth rates, it is less suitable for businesses that do not pay dividends or whose dividends are highly irregular. Its reliance on assumptions makes the valuation highly sensitive to inputs, but for dividend-focused investors and certain equity analysts, the DDM offers a clear, theory-driven way to link expected cash returns to a stock’s value.