The dividend discount model (DDM) is a way of valuing a company based on the theory that a stock is worth the discounted sum of all of its future dividend payments. In other words, it is used to value stocks based on the net present value of the future dividends. The equation most always used is called the "Gordon Growth Model. " It is named after Myron J. Gordon who originally published it in 1959, although the theoretical underpin was provided by John Burr Williams in his 1938 text The Theory of Investment Value.
The variables and equation are:
- P is the current stock price.
- g is the constant growth rate in perpetuity expected for the dividends.
- r is the constant cost of equity for that company.
- D1 is the value of the next year's dividends.
- There is no reason to use a calculation of next year's dividend using the current dividend and the growth rate, when management commonly disclose the future year's dividend, and websites post it.
Income plus capital gains equals total return:
The equation can also be understood to generate the value of a stock such that the sum of its dividend yield (income) plus its growth (capital gains) equals the investor's required total return. Consider the dividend growth rate as a proxy for the growth of earnings and by extension the stock price and capital gains. Consider the company's cost of equity capital as a proxy for the investor's required total return.
Income + Capital Gain = Total Return
Dividend Yield + Growth = Cost of Equity
Problems with the Model
- a) The presumption of a steady and perpetual growth rate less than the cost of capital may not be reasonable.
- b) If the stock does not currently pay a dividend, like many growth stocks, more general versions of the discounted dividend model must be used to value the stock. One common technique is to assume that the Miller-Modigliani hypothesis of dividend irrelevance is true and, therefore, replace the stocks's dividend D with E earnings per share. However, this requires the use of earnings growth rather than dividend growth, which might be different.
- c) The stock price resulting from the Gordon model is hypersensitive to the growth rate chosen.