What is the DDM (Dividend Discount Model)?
Dividend Discount Model Formula
The Dividend Discount Model, or DDM, is one of the most common valuation models.
Because investors expect to earn interest on their money over time, money today is worth more than the same value paid out at a later date.
This is why future payouts are “discounted”when computing their value today.
The rate at which future dividends are discounted is known as the weighted average cost of capital.
The weighted average cost of capital, or WACC, is the “opportunity cost“of what the investor’s money could have made if it were invested elsewhere.
The Dividend Discount Model also factors in an estimated perpetual increase of the dividend payout made over time based on historical increases of the dividend payout.
The present value of future dividends is equal to the estimated value of the stock.
If the present value of future dividends calculated by the DDM is greater than the current price of the stock, then the DDM suggests it is a buying opportunity.
A major limitation of the Dividend Discount Model is that it can only be used if the company pays a dividend and the dividend returns are stable and predictable.