Dividend Discount Model (DDM) is a stock valuation method that determines the intrinsic value of a stock based on its future dividend payments, discounted at the required rate of return. It assumes that a stock’s price is the present value of all expected future dividends. DDM has three main types: No-Growth Model (dividends remain constant), Constant Growth Model (dividends grow at a fixed rate), and Two-Stage Growth Model (dividends grow rapidly initially before stabilizing). It is most effective for valuing dividend-paying stocks.
The dividend discount model can take several variations depending on the stated assumptions.
1. No-Growth Dividend Discount Model (Zero Growth Model)
No-Growth DDM assumes that dividends remain constant over time without any growth. This model is suitable for companies operating in mature industries where dividend payouts are stable and predictable.
Formula
P0 = D / r
Where:
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P0 = Present value of the stock
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D = Constant annual dividend
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r = Required rate of return
Interpretation
Since dividends remain unchanged, the stock is valued as a perpetuity. This model is useful for companies that have no expansion plans and generate consistent profits, such as utility companies and government-backed corporations.
Example
If a company pays a fixed dividend of ₹10 per share and the required rate of return is 8%, the stock price will be:
P0 = 10 / 0.08 = ₹125
2. Gordon Growth Model (Constant Growth Dividend Discount Model)
The Gordon Growth Model (GGM) is one of the most commonly used variations of the dividend discount model. The model is called after American economist Myron J. Gordon, who proposed the variation.
The GGM is based on the assumptions that the stream of future dividends will grow at some constant rate in future for an infinite time. Mathematically, the model is expressed in the following way:
Where:
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V0: The current fair value of a stock
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D1: The dividend payment in one period from now
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r: The estimated cost of equity capital (usually calculated using CAPM)
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g: The constant growth rate of the company’s dividends for an infinite time
3. One-period Dividend Discount Model (Two-Stage Growth Dividend Discount Model)
The one-period discount dividend model is used much less frequently than the Gordon Growth model. The former is applied when an investor wants to determine the intrinsic price of a stock that he or she will sell in one period from now. The one-period dividend discount model uses the following equation:
Where:
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V0: The current fair value of a stock
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D1: The dividend payment in one period from now
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P1: The stock price in one period from now
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r: The estimated cost of equity capital
4. Multi-period Dividend Discount Model (Two-Stage Growth Dividend Discount Model)
The multi-period dividend discount model is an extension of the one-period dividend discount model wherein an investor expects to hold a stock for the multiple periods. The main challenge of the multi-period model variation is that forecasting dividend payments for different periods is required. The model’s mathematical formula is below:
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