Theoretical finance is often a very complex topic and it is frequently used by financial professionals to make decisions. The Dividend Discount Model (DDM) is one of the most popular valuation models in this field. This model is based on the concept of the time value of money and is used to determine the intrinsic value of a firm or business.
In this article, we’ll discuss how to apply DDM to value stocks. You can also learn how to calculate the present value of a company’s dividend payments using the Dividend Discount Model (DDM) formula. It’s often used by investors to determine a company’s present value. Aside from the dividend discount model, we will also discuss the Capital Asset Pricing Model (CAPM), as these two models are closely tied.
The Dividend Discount Model is a widely used valuation technique in the world of investing. But, it’s sometimes difficult to calculate. That’s why we recommend using our calculator. With this handy tool, you can easily estimate stock value based upon the DDM formula. We also recommend that you use our dividend calculator for the best results. Without further ado, let’s dig into it.
Dividend Discount Model (DDM) – What Is It?
The dividend discount model (DDM) is a technique that can help you get a better idea of stock valuation. This is a popular technique for valuing stocks. The model calculates the value of a stock by equating the stock price to the present value of all future dividends.
In this model, it is assumed that the stock value is equivalent to the total of all of the future dividend payments made by the company, providing that they are discounted or reduced to the present value. This approach lets us determine the exact value of a company no matter what its present stock price is. It is important to note that the market’s current condition has an influence on stock prices, so it doesn’t precisely mirror the company’s value sometimes.
The DDM is based on two assumptions:
- The company will continue to pay out dividends at the same rate in perpetuity, and
- The company will never grow its dividend.
As for the present value, it’s closely connected to the time value of money (TVM) concept. In a nutshell, this concept shows how the value of a sum of money changes over time.
The time value of money (TVM) is applicable in almost all financial transactions, but it can be applied to other areas such as real estate, investments, and personal finance. The TVM formula takes into account the following four factors: present value, interest rate, number of payments per year, and the number of years in which the loan will be repaid.
DDM Formula
Now that you know more about the Dividend Discount Model (DDM), you should also learn how to calculate the present stock value. It’s calculated using the DDM formula. As a matter of fact, the Dividend Discount Model is a method of valuing stocks by using the following formula:
Present stock value = Expected dividend / (Cost of equity – Expected growth rate)
Example:
- Expected Dividend: $10.29
- Cost of Equity: 4.40%
- Expected Growth Rate: 2.94%
In our example, the present stock value is $704.79. It’s calculated this way:
Present stock value = 10.29 / (0.044 – 0.0294)
Present stock value = 10.29 / 0.0146
Present stock value = $704.79
This calculation is based on the Gordon Growth Model (GGM). It is widely used for commuting the Dividend Discount Model (actually the present stock value) thanks to its simplicity. This simple model is used to grow a company. It was developed by Bruce D. Henderson in the 1960s and it has been used for over 50 years. The model consists of 4 phases:
- Market Development Phase
- Product Development Phase
- Market Penetration Phase
- Product Differentiation Phase
The Components of the DDM Formula
When calculating the current stock price or present stock value, it is necessary to factor in the cost of equity and the expected growth rate. You should also take into account the required rate of return on the stock and the expected dividend payment.
Simply enter these variables into the right fields of our calculator and commute the present stock value in the blink of an eye. Let’s throw light on each component of this formula for better understanding.
- Present stock value – It indicates the current worth of the stock. Stock values are an important indicator of the performance of a company. It is often used to judge the financial health and stability of a company. Stock value is calculated by multiplying the number of shares by the current share price.
- Expected dividend (we think of dividend payable in 12 months) – It’s the amount of money obtained in the following dividend period. As you may already know, dividends are the payments made by a company to its shareholders from the company’s profits. They are usually paid out twice per year, with the number of dividends varying from company to company. Dividends can be paid in the form of cash or shares.
- Cost of equity – Investors are looking for the best return on their investment and want to make sure that they are not taking on more risk than they want. The cost of equity is a measure of this risk. It is the lowest rate of return investors are looking for when purchasing stocks. The cost of equity is determined by the riskiness of the market conditions as well as the company’s industry, size, and financial strength.
- Expected growth rate – It represents the rate of dividends we can expect in the future. The expected growth rate is a percentage value. In fact, the expected growth rate of dividends is a measure of future dividend payments. It is calculated by taking the current dividend and dividing it by the current price. In order to calculate it, you should first find out what the current dividend payment is for stock and divide that amount by the current share price. The resulting number will be what analysts expect for future dividend payments from the company.