What is the DDM?
The dividend discount model (DDM) is a method for assessing the present value of a stock based on the growth rate of dividends.
How the DDM Works
The dividend discount model (DDM) seeks to estimate the current value of a given stock on the basis of the spread between projected dividend growth and the associated discount rate. The DDM calculates this present value in the following manner:
Present Stock Value = DividendShare / (RDiscount – RDividend Growth)
In the DDM, a present stock value that is higher than a stock's market value indicates that the stock is undervalued and that it is a good time to purchase shares.
To illustrate, suppose stock XYZ declares a dividend of two dollars per share and is currently valued at $125 in the market. Based on the stock's dividend history, a broker determines a dividend growth rate for the stock of five percent per year and a discount rate of seven percent. The present stock value is calculated as follows:
Present Stock Value = $2.00 per share / (0.07 discount – 0.05 dividend growth)
= $2.00 / 0.02
With a calculated present value of $100 against a market value of $125, stock XYZ is overvalued in this instance and represents an opportunity to sell.
Why the DDM Matters
The DDM is a tool used by many investors and analysts as a simple method to choosing stocks. The greatest disadvantage of the DDM is that it is inapplicable to companies which do not pay dividends.