What it means
The logic behind the model is simple. If you own a share forever, the only cash you are certain to receive from the company is its dividends, so the share should be worth the present value of those payments.
The further away a dividend, the less it is worth today, which is why each one is discounted. The best-known version is the Gordon growth model, which assumes dividends grow at a steady rate for ever.
It reduces the whole infinite stream to a single tidy formula: next year's dividend divided by the required return minus the growth rate. That simplicity makes it popular for quick valuation of mature, dividend-paying businesses such as utilities and consumer staples.
The required return, often called the cost of equity, is the annual return investors demand for holding the share given its risk. The growth rate should be a sensible long-term figure, and it must be lower than the required return, otherwise the formula breaks down and produces nonsense.
Small changes to either input move the answer a lot. DDM works best for companies with stable, predictable dividends.
It is much less useful for young growth companies that pay nothing, or for businesses that prefer buying back shares to paying dividends. For those, analysts usually turn to discounted cash flow or earnings multiples instead.
A common variant is the multi-stage DDM, which allows fast growth for several years and then a slower, steady rate. It is more realistic for companies that are maturing, though it needs more assumptions and so more judgement.
One more nuance is that the model values only what shareholders receive as dividends, so it ignores cash the company retains and reinvests. If a business keeps most of its profit to fund growth, the DDM can understate what the shares are worth unless growth is built into the forecast.
In practice
Real-world examples.
Example
An income-focused fund manager uses a DDM to compare two electricity companies. The one trading well below its model value goes on the shortlist for the portfolio.
Example
A retired investor values a bank share that has paid steadily rising dividends for decades. The DDM helps decide whether the price is fair before buying more.
Example
An analyst covering a fast-growing software firm finds the DDM unusable because the firm pays no dividend. She switches to a cash flow model instead.
Formula
Calculation
Formula (Gordon growth): Value per share = D1 / (r - g), where D1 is next year's expected dividend, r is the required return and g is the constant growth rate.
Worked example: a utility company paid a dividend of $2.00 per share this year. Dividends are expected to grow by 4% a year, and investors require a 9% return.
D1 = $2.00 x 1.04 = $2.08
Value per share = $2.08 / (0.09 - 0.04)
Value per share = $2.08 / 0.05 = $41.60
If the shares trade at $35.00 the model suggests they look undervalued, and if they trade at $50.00 it suggests they look expensive, assuming the inputs are reasonable.Case study
Seen in the real world.
Tideway Water is a fictional listed water utility used here as an illustrative example. An analyst built a DDM using a $3.00 current dividend, 3% growth and an 8% required return. That gave a value of $3.09 / 0.05 = $61.80 per share against a market price of $52.
Before recommending a purchase, she tested the sensitivity. Raising the required return by one point to 9% cut the value to $3.09 / 0.06 = $51.50, roughly the market price. This illustrative story shows why the analyst presented a range rather than a single number, and why one percentage point of discount rate can erase an apparent bargain.
She concluded that the shares were fairly valued within a sensible range, and the investment committee decided to wait for a lower price before buying.
Watch out
Common mistakes.
- Using a growth rate higher than the required return. The formula then gives a negative or meaningless value.
- Applying the model to companies that pay no dividends. It needs a genuine dividend stream to work.
- Treating the answer as exact. Tiny changes to inputs can shift the value by 20% or more.
Questions
People also ask.
Which companies suit the DDM?
Mature businesses with long histories of stable or steadily growing dividends. Utilities, consumer staples and some banks are typical examples.
How do I choose the growth rate?
Use a long-term rate that the business can plausibly sustain, usually no higher than the growth of the wider economy. Deriving it from retention and return on equity is another common method.
Is DDM the same as DCF?
They share the same discounting idea, but the DDM discounts dividends while a DCF discounts free cash flow. The DDM is narrower and suits dividend payers.
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