dividenddiscount

The dividend discount model (DDM) is a method for valuing a stock by estimating the present value of expected future dividends, discounted at the investor's required rate of return. It rests on the premise that a stock's value is equal to the present value of the stream of future dividends.

The Gordon growth model is the simplest form, assuming dividends grow at a constant rate g forever. The formula P0 = D1 / (r - g), where D1 is the dividend expected next year, r is the required return, and g < r. If dividends are not growing, a zero-growth variant gives P0 = D1 / r.

More complex forms allow non-constant growth, using multi-stage models. In a two-stage model, dividends grow at rate g1 for a period, then switch to a perpetual rate g2. The present value is the sum of the discounted dividends during the high-growth phase plus the terminal value of the perpetual stream.

Inputs and usage: the model requires estimates of expected dividends (or payout policy), growth assumptions, and the discount rate. It is commonly used for mature, dividend-paying firms and as a framework in fundamental analysis to assess whether a stock is fairly valued relative to its payout prospects.

Limitations and criticisms: the DDM relies on forecastable dividends and stable growth, making it highly sensitive to r and g. It is less applicable to non-dividend-paying or highly irregular firms and to situations with changing risk. It also assumes perpetual payouts and neglects other value drivers, such as share repurchases or changes in capital structure.

History: the approach is associated with the dividend discount idea in early financial theory, with Gordon and Williams among its influential contributors. It remains a foundational tool in equity valuation and financial education.