What it means
A share is a claim on a company's future cash distributions, and its value is what those distributions are worth today. The dividend discount model takes that statement literally.
It forecasts the dividends the share will pay, discounts each at the rate of return an investor requires, and sums the results. Because a company is assumed to continue indefinitely, the forecast has to be simplified with an assumption about long-run growth, and the mathematics of a growing perpetuity gives the model its familiar form.
The result is an intrinsic value that can be compared with the market price: if the value is higher, the share is cheap on the model's assumptions; if lower, it is dear. The constant growth version, often called the Gordon growth model, assumes that the dividend just paid will grow at a steady rate forever, and that the required return exceeds the growth rate.
It works well for mature, stable companies with a long dividend record and predictable growth: utilities, consumer staples, banks in steady conditions. It fails for companies that pay no dividend, whose value must be found from the cash flows that could eventually be paid; for companies whose growth exceeds the required return, which cannot last but makes the formula meaningless; and for companies in transition, whose near-term growth differs from their long-run rate.
Multi-stage versions handle the transition. A two-stage model forecasts dividends explicitly for a period of higher growth, then applies the constant growth formula from the point at which growth is expected to settle, discounting that terminal value back to today.
Three-stage models add a period of declining growth between the two. These extensions make the model more realistic and more work, and they shift the sensitivity from a single growth rate to the length and rate of the high-growth phase, but the logic is unchanged: the value is the discounted sum of all expected dividends.
The required return is the model's other input, and it is usually estimated from the capital asset pricing model: the risk-free rate plus the share's beta multiplied by the equity risk premium. Each element is an estimate.
The model can also be run in reverse: given the market price and the current dividend, it can solve for the growth rate the market is implying, or for the return the market is offering, which is often a more useful way to use it than as a source of a single "correct" price. An implied growth rate that is implausibly high is a warning that the market is optimistic; one that is low is a sign of pessimism or of a company whose dividend the market expects to be cut.
The model's sensitivity is its defining feature. Because the value depends on the difference between the required return and the growth rate, and that difference is usually a few percentage points, small changes in either move the value a great deal: a one-point change in either can move the value by 20% or more.
This is not a flaw in the model so much as a truth about equity values, which really are that sensitive to expectations about growth and risk. But it means the model's output should be presented as a range with its sensitivities, and cross-checked against other methods, rather than as a single figure.
Its main practical value is in making explicit what an investor must believe about growth and risk to justify a given price.
In practice
Real-world examples.
Example
An analyst values a water utility paying $1.05 a share, growing at 3%, at a 7.5% required return: $1.08 / 0.045 = $24.00, against a market price of $22.50, and rates the share a modest buy.
Example
A pension fund uses the model in reverse across its equity portfolio to estimate the return the market is offering, which it compares with bond yields to set its asset allocation.
Example
An investor tries to apply the model to a technology company paying no dividend and concludes that it must be valued on the free cash flow it could eventually distribute, which is the same logic with a different cash flow.
Think of it
“The dividend discount model is like valuing a rental property by the present value of future rent payments you'll collect.
Formula
Calculation
Constant growth model: Value per share = D1 / (r minus g), where D1 = next year's expected dividend = D0 x (1 + g), r = required return, g = long-run growth rate
Multi-stage: Value = Sum of discounted dividends for the explicit period + Discounted terminal value, where Terminal value at the end of year n = D(n+1) / (r minus g)
Required return (CAPM) = Risk-free rate + Beta x Equity risk premium
Implied growth rate: solve D0 x (1 + g) / (r minus g) = Price for g
Worked example: constant growth. A company has just paid a dividend of $2.00 a share. Dividends are expected to grow at 4% a year indefinitely. The risk-free rate is 4%, the equity risk premium 5% and the share's beta 1.0, so the required return is 4% + 1.0 x 5% = 9%.
- D1 = $2.00 x 1.04 = $2.08
- Value = $2.08 / (0.09 minus 0.04) = $2.08 / 0.05 = $41.60
Sensitivity. With a required return of 8%: $2.08 / 0.04 = $52.00. With growth of 5%: $2.10 / 0.04 = $52.50. With a required return of 10% and growth of 3%: $2.06 / 0.07 = $29.43. A one-point change in either input moves the value by about 25%.
Worked example: two-stage. The same company is expected to grow its dividend at 12% a year for three years, then at 4% thereafter.
- D1 = $2.24; D2 = $2.51; D3 = $2.81
- Present values at 9%: $2.24 / 1.09 = $2.06; $2.51 / 1.1881 = $2.11; $2.81 / 1.2950 = $2.17; total $6.34
- Terminal value at end of year 3 = D4 / (r minus g) = $2.81 x 1.04 / 0.05 = $58.45; present value = $58.45 / 1.2950 = $45.13
- Value = $6.34 + $45.13 = $51.47; the three years of faster growth add about $10 to the constant growth value
Implied growth. If the share trades at $50 and the required return is 9%: $2.00 x (1 + g) / (0.09 minus g) = $50, which solves to g = 4.8%. The market is pricing in slightly faster growth than the 4% assumed.Case study
Seen in the real world.
An investment committee was considering a large holding in a listed electricity utility whose shares traded at $50 and whose dividend had just been raised to $2.00 a share. The analyst's dividend discount valuation, using 4% growth and a 9% required return, gave $41.60, and the analyst recommended against buying on the grounds that the shares were 20% overvalued. A committee member with a longer memory asked for the sensitivity table, and the discussion changed.
At a required return of 8.5%, which was arguably justified by the utility's low beta of 0.8 (4% + 0.8 x 5% = 8%, or 8.5% with a margin), the value was $46.22 at 4% growth and $59.43 at 4.5%. The implied growth rate at the $50 price and a 9% required return was 4.8%; at 8.5% it was 4.3%.
The utility's regulator had just approved a five-year investment programme that supported dividend growth of about 5% over that period, after which the analyst's 4% long-run rate was reasonable. A two-stage model with 5% for five years and 4% thereafter, at an 8.5% required return, gave $53.50.
The committee's conclusion was that the model had not shown the share to be overvalued; it had shown that the share's value depended on whether one believed the dividend would grow at 4% or 5% and whether the utility's risk justified an 8.5% or 9% required return, and that reasonable people could hold either view. The committee bought a half-sized position, on the reasoning that the share was fairly priced on defensible assumptions and that the analyst's original figure had been one point in a range from $42 to $59. The analyst's lesson, recorded in the committee's notes, was that a dividend discount valuation presented as a single number is an assertion about growth and risk in disguise, and that the sensitivity table is the valuation.
Watch out
Common mistakes.
- Using the dividend just paid rather than next year's expected dividend in the numerator, which understates the value by a year's growth.
- Presenting a single value without sensitivities, when a one-point change in the required return or the growth rate moves the answer by 20% or more.
- Applying the constant growth model to a company whose growth rate is near or above the required return, or whose dividends are irregular, where the formula gives an absurd or meaningless result.
Questions
People also ask.
What is the difference between the dividend discount model and a discounted cash flow valuation?
Both discount future cash flows. The dividend discount model discounts the dividends paid to shareholders; a DCF valuation discounts the free cash flow the business generates, whether or not it is paid out, and deducts debt to reach the equity value. For a company that pays out all its free cash flow, they converge.
Why does the model require the growth rate to be below the required return?
Because a dividend growing faster than the discount rate forever would have an infinite present value. No company grows faster than the economy forever, so the long-run growth rate should be modest, typically at or below the growth rate of the economy.
How is the model useful if it is so sensitive?
By making the assumptions explicit. Running it in reverse, to find the growth rate or return the market price implies, tells an investor what they must believe to justify the price, which is often more useful than a single "correct" value.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%