Dividend Discount

The dividend discount model (DDM) values a stock as the present value of all expected future dividends. It is based on the principle that a stock's worth equals the discounted sum of future cash flows paid to shareholders.

Most applicable to companies that pay regular, predictable dividends (e.g., utilities, mature blue-chip companies).

Basic Dividend Discount Model

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.

Stock Value=Dr\text{Stock Value} = \frac{D}{r}
  • 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

Gordon Growth Model (Constant Growth DDM)

The Gordon Growth Model extends the basic DDM by assuming dividends will grow at a constant rate each year.

Stock Value=D1r−g\text{Stock Value} = \frac{D_1}{r - g}
  • 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

Critical Assumptions

  • 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.

Effect of Variables on Stock Value

ChangeEffect on Value
Dividend increasesValue increases
Required return increasesValue decreases
Growth rate increasesValue increases
Growth rate approaches required returnValue approaches infinity (model breaks down)

Exam Tip: Gotchas

  • Watch 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.