Dividend Discount Models: No Growth, Constant Growth, and Two Stage Growth Model, Assumptions

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:

• P0​ = Present value of the stock

• D = Constant annual dividend

• 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:

• V_0: The current fair value of a stock

• D_1: 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 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:

• V_0: The current fair value of a stock

• D_1: The dividend payment in one period from now

• P₁: The stock price in one period from now

• 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:

Assumptions of Dividend Discount Models:

1. Dividends Determine Share Value

The Dividend Discount Model assumes that the value of a company’s share is determined solely by the present value of its future dividend payments. Dividends are considered the only cash flows received by shareholders and therefore form the basis for calculating the intrinsic value of a stock. The model assumes that investors purchase shares primarily to earn future dividends. Other factors such as market speculation or temporary price fluctuations are not considered in valuation. This assumption makes the model suitable for companies that regularly distribute profits through dividends and maintain a consistent dividend payment policy.

2. Regular and Predictable Dividend Payments

The model assumes that the company pays dividends regularly and consistently over time. Future dividend payments should be predictable so that investors can estimate their present value accurately. Companies with irregular or uncertain dividend policies are difficult to value using the Dividend Discount Model. Stable dividend payments reduce uncertainty and improve the reliability of valuation. This assumption is generally valid for mature and financially stable companies that have a long history of paying dividends. Predictable dividend distributions enable investors to estimate future cash flows and make informed long term investment decisions.

3. Constant Dividend Growth Rate

The Dividend Discount Model assumes that dividends grow at a constant and sustainable rate over the long term. This assumption is especially important in the Gordon Growth Model, where dividend growth remains unchanged every year. Constant growth reflects stable earnings, sound financial management, and consistent business expansion. Although short term dividend growth may vary, the model assumes that long term growth remains stable. This assumption simplifies the valuation process and is suitable for well established companies with predictable earnings and dividend policies rather than rapidly growing or highly volatile businesses.

4. Required Rate of Return Remains Constant

The model assumes that the investor’s required rate of return remains constant throughout the investment period. The required return represents the minimum rate of return expected for the risk associated with the investment and is used as the discount rate. A stable discount rate ensures consistency in calculating the present value of future dividends. The model does not account for changes in market interest rates, inflation, or investment risk over time. Therefore, this assumption is more appropriate when economic conditions and investor expectations remain relatively stable during the valuation period.

5. Growth Rate is Lower than the Required Return

The Dividend Discount Model assumes that the dividend growth rate is always lower than the investor’s required rate of return. This condition is necessary for the valuation formula to produce a valid and meaningful intrinsic value. If the growth rate becomes equal to or greater than the required return, the calculated share value becomes unrealistic or mathematically undefined. Mature companies usually satisfy this assumption because their long term growth rates remain moderate. Maintaining a growth rate below the required return ensures that future dividend values can be discounted properly and accurately reflects the company’s intrinsic value.