Quick Answer
The Dividend Discount Model values a stock as the present value of its expected future dividends. The Gordon Growth Model version is Stock Value = D1 / (r - g), and it only works when r exceeds g. DDM fits mature, dividend-paying companies best and is not useful for non-dividend-paying growth stocks.
Fundamental analysis, covered in the previous lesson, explains why an analyst looks at a company's numbers. DDM turns that reasoning into a specific formula that converts a dividend forecast into a single price target.
What Is the Core Idea Behind DDM?
- The Dividend Discount Model (DDM) values a stock based on the present value of its expected future dividends
- Logic: if you own a stock forever, the only cash you receive is dividends, so the stock's value equals the present value of all those future dividend payments
- Incorporates the time value of money: a dollar received next year is worth less than a dollar today
Think of it this way: If the only reason you hold a stock forever is for its dividend checks, the stock is worth whatever all those future checks add up to in today's dollars.
How Do You Calculate the Gordon Growth Model?
The version of DDM this exam tests is the Gordon Growth Model (also called the constant growth DDM):
Where:
- D1 = Next year's expected dividend (not the current dividend)
- r = Required rate of return (the investor's minimum acceptable return)
- g = Constant dividend growth rate (assumed to continue indefinitely)
Example Calculation
A stock currently pays a $2.00 annual dividend. Dividends are expected to grow at 5% per year. Your required rate of return is 10%.
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D1 = $2.00 x 1.05 = $2.10 (next year's expected dividend)
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Stock Value = $2.10 / (0.10 - 0.05) = $2.10 / 0.05 = $42.00
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If the stock is trading at $35, it appears undervalued (intrinsic value $42 > market price $35)
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If the stock is trading at $50, it appears overvalued (intrinsic value $42 < market price $50)
Exam Tip: Gotchas
- D1 is next year's dividend, not the current one. If given the current dividend, multiply by (1 + g) to get D1. This is a common exam trap.
- The formula breaks when g >= r. If the growth rate equals or exceeds the required return, the denominator becomes zero or negative, producing a meaningless result.
What Does DDM Assume, and Where Does It Break Down?
| Assumption | Why It Matters |
|---|---|
| Dividends grow at a constant rate indefinitely | Rarely true in reality; growth rates change over time |
| Required return must exceed growth rate (r > g) | If g >= r, the formula produces a negative or infinite value (meaningless) |
| Company pays dividends | Not useful for non-dividend-paying growth stocks |
When Does DDM Work Best, and When Does It Fail?
- Mature, stable companies with a long history of paying and increasing dividends
- Companies in sectors like utilities, consumer staples, and financials
- Blue-chip stocks with predictable, steady growth
DDM is not useful for growth companies that reinvest all earnings instead of paying dividends, companies with erratic or declining dividend patterns, or startups and early-stage companies.
Exam Tip: Gotchas
- DDM is not useful for non-dividend-paying stocks. If a question describes a tech startup that has never paid a dividend, DDM is not the right model. If it describes a utility company with 20 years of steady dividend increases, DDM is a good fit.
- DDM ignores capital gains. It values the stock based on dividends only, not stock price appreciation.
What Should You Check on Exam Day?
- Convert a current dividend to D1 by multiplying by (1 + g) before plugging it into the formula
- Confirm r > g before trusting a Gordon Growth Model result; if g >= r, the formula is not usable
- Match DDM to mature, dividend-paying companies, not non-dividend-paying growth stocks
- Remember DDM values dividends only; it does not account for capital gains