Quick Answer
The dividend discount model (DDM) values a stock as the present value of all expected future dividends. The basic version divides one year's dividend by the required return; the Gordon Growth Model divides next year's expected dividend by the required return minus a constant growth rate, and only applies to steady dividend payers.
Most applicable to companies that pay regular, predictable dividends (e.g., utilities, mature blue-chip companies). The exam typically gives you the inputs and asks you to plug them into the correct version of the formula.
How Does the Basic Dividend Discount Model Work?
It is based on the principle that a stock's worth equals the discounted sum of future cash flows paid to shareholders.
Think of it this way: The DDM asks: "What is a stream of future dividend payments worth to me today?" It is like asking how much you would pay now for a rental property based on its expected future rent checks.
- D = annual dividend per share
- r = required rate of return (discount rate)
Example:
- Stock pays a $2.00 annual dividend
- Required return: 5%
- Value: $2.00 / 0.05 = $40.00
How Does the Gordon Growth Model Extend the DDM?
The Gordon Growth Model extends the basic DDM by assuming dividends will grow at a constant rate each year.
- D1 = next year's expected dividend
- r = required rate of return
- g = constant annual dividend growth rate
Example:
- Next year's expected dividend: $2.10
- Required return: 8%
- Growth rate: 3%
- Value: $2.10 / (0.08 - 0.03) = $2.10 / 0.05 = $42.00
What Assumptions Does the Model Require?
- Dividends grow at a constant rate forever (Gordon model)
- Required rate of return (r) must be greater than growth rate (g); otherwise the formula produces a negative or infinite value
- Model works best for stable, dividend-paying companies with predictable growth
Exam Tip: Gotchas
- The Gordon model breaks when g ≥ r. If growth rate meets or exceeds the required return, the formula produces a negative or infinite value; it's mathematically undefined, not "infinitely valuable." A question where g > r has no valid Gordon answer; the model is inappropriate.
How Do Changes in Inputs Affect Stock Value?
| Change | Effect on Value |
|---|---|
| Dividend increases | Value increases |
| Required return increases | Value decreases |
| Growth rate increases | Value increases |
| Growth rate approaches required return | Value approaches infinity (model breaks down) |
Exam Tip: Gotchas
- The formula changes depending on whether a question gives D0 or D1. D0 is the dividend just paid. D1 is next year's expected dividend. If given D0, you must calculate D1 = D0 x (1 + g) before applying the Gordon formula. Using the wrong dividend is a common exam trap.
- DDM is a special case of discounted cash flow (DCF). DDM uses dividends as the cash flow; DCF uses free cash flow and is more broadly applicable. If a company pays no dividends, use DCF instead.
Why Does a Small Change in the Growth Rate Move Value So Much?
The growth rate is subtracted from the required return, and the result sits under the dividend: V = D1 / (r - g). When r - g is small, a small change in g changes that difference by a large percentage.
Example: D1 = $2.00 and r = 8%.
| Growth rate (g) | r - g | Value = $2.00 / (r - g) |
|---|---|---|
| 3% | 0.05 | $40.00 |
| 4% | 0.04 | $50.00 |
A 1 percentage point rise in g shrinks the denominator from 0.05 to 0.04, a 20% drop. The same $2.00 divided by a number 20% smaller gives a value 25% larger ($10.00 more). Value does not move by a fixed number of dollars per point of growth.
Exam Tip: Gotchas
- A growth rate of zero gives the basic DDM. With g = 0, $2.00 / 0.08 = $25.00. Any positive g in the Gordon model gives a value above that.
How Do You Compare the DDM Value to the Market Price?
The DDM result is the stock's intrinsic value, the price the model says the stock is worth. You compare it to what the stock actually trades for.
| Comparison | Conclusion |
|---|---|
| Intrinsic value is above market price | Stock is undervalued (the market charges less than the model says it is worth) |
| Intrinsic value is below market price | Stock is overvalued (the market charges more than the model says it is worth) |
| The two are about equal | Stock is fairly valued |
Example: The DDM gives $65 and the stock trades at $58. Value ($65) is above price ($58), so the stock is undervalued.
Exam Tip: Gotchas
- Read which number is larger, then pick the label. Answer options often pair a true fact with the wrong label, such as "overvalued, since its intrinsic value exceeds the market price." The fact is true and the label is reversed. Intrinsic value above price always means undervalued.
What Should You Check on Exam Day?
- Can you compute the basic DDM (D / r) and the Gordon Growth Model (D1 / (r - g)) from given inputs without mixing up D0 and D1?
- Can you compare a DDM value to the market price and label the stock undervalued, overvalued, or fairly valued?
- Can you explain why the Gordon model breaks down when g meets or exceeds r, rather than calling the stock "infinitely valuable"?
- Can you state, without hesitating, the direction each input moves value: dividend up, required return up, growth rate up?
- Can you identify when DDM is the wrong tool because the company pays no dividends, and name DCF as the alternative?