Dividend Discount Model (DDM)

The Dividend Discount Model (DDM) values a stock based on the theory that it's worth the sum of all future dividend payments, discounted back to their present value.

Gordon Growth Model (Simplest DDM): Stock Value = D₁ / (r - g)

Where:

• D₁: Expected dividend next year
• r: Required rate of return (discount rate)
• g: Dividend growth rate (must be < r)

Example:

• Current Dividend: $2.00
• Expected Growth: 5% per year
• Required Return: 10%
• D₁ = $2.00 × 1.05 = $2.10
• Value = $2.10 / (0.10 - 0.05) = $42.00

Multi-Stage DDM: For companies with changing growth rates:

1. Stage 1: High growth period (e.g., 15% for 5 years)
2. Stage 2: Transition period
3. Stage 3: Mature growth (perpetuity at 3-4%)

DDM Variations:

Model	Growth Assumption	Best For
Zero Growth	No dividend growth	Preferred stock
Constant Growth (Gordon)	Fixed growth forever	Mature dividend payers
Two-Stage	High then low growth	Growing companies
H-Model	Linear declining growth	Growth transitioning

When DDM Works Best:

• Mature, stable dividend payers
• Utilities, consumer staples
• Companies with long dividend history
• REITs (required to pay dividends)

Limitations:

• Only works for dividend-paying stocks
• Highly sensitive to growth assumption
• Assumes constant growth (unrealistic)
• Doesn't work if g ≥ r
• Many quality companies don't pay dividends

Sensitivity Analysis:

Growth Rate	Required Return 8%	Required Return 10%
3%	$42.00	$30.00
4%	$52.50	$35.00
5%	$70.00	$42.00

Small changes in assumptions cause large value changes!