Tag: Constant Growth DDM

The Dividend Discount Model (DDM) is a stock valuation method used to estimate the intrinsic value of a company’s share based on the present value of its expected future dividends. The model assumes that the value of a share is equal to the total present value of all future dividend payments received by shareholders. Since dividends represent the cash flow earned from owning a share, they are discounted to their present value using the required rate of return. The Dividend Discount Model is most suitable for companies that pay regular and stable dividends. Investors use DDM to determine whether a stock is undervalued or overvalued by comparing its intrinsic value with its current market price, thereby supporting informed investment decisions.

Types of Dividend Discount Model:

1. Gordon Growth Model (Costant)

The Gordon Growth Model (GGM) is one of the most commonly used variations of the dividend discount model. The model is called after American economist Myron J. Gordon, who proposed the variation.

The GGM is based on the assumptions that the stream of future dividends will grow at some constant rate in future for an infinite time. Mathematically, the model is expressed in the following way:

Where:

• V₀ – the current fair value of a stock
• D₁ – the dividend payment in one period from now
• r – the estimated cost of equity capital (usually calculated using CAPM)
• g – the constant growth rate of the company’s dividends for an infinite time

2. One-period Dividend Discount Model

The one-period discount dividend model is used much less frequently than the Gordon Growth model. The former is applied when an investor wants to determine the intrinsic price of a stock that he or she will sell in one period from now. The one-period dividend discount model uses the following equation:

Where:

• V₀ – the current fair value of a stock
• D₁ – the dividend payment in one period from now
• P₁ – the stock price in one period from now
• r – the estimated cost of equity capital

3. Multi-period Dividend Discount Model

The multi-period dividend discount model is an extension of the one-period dividend discount model wherein an investor expects to hold a stock for the multiple periods. The main challenge of the multi-period model variation is that forecasting dividend payments for different periods is required. The model’s mathematical formula is below:

Assumption of Dividend Discount Model:

1. Regular Dividend Payments

The Dividend Discount Model assumes that the company pays dividends regularly to its shareholders. Since the model values a share based on future dividend payments, companies that do not distribute dividends cannot be accurately valued using this method. Regular dividend payments provide a predictable stream of cash flows that can be discounted to determine the intrinsic value of the share. Therefore, the model is most suitable for established companies with a consistent dividend policy. Stable dividend payments enable investors to estimate future returns more accurately and make reliable investment decisions using the Dividend Discount Model.

2. Constant Dividend Growth Rate

The Dividend Discount Model assumes that dividends grow at a constant rate every year. This assumption is particularly important in the constant growth version of the model, also known as the Gordon Growth Model. It assumes that the company’s earnings and dividend payments increase steadily over the long term. A constant growth rate simplifies the valuation process and allows investors to estimate the present value of future dividends. Although actual dividend growth may fluctuate, the model assumes long term stability. This assumption is most appropriate for mature companies with stable earnings and predictable dividend growth patterns.

3. Required Rate of Return Remains Constant

The model assumes that the investor’s required rate of return remains constant throughout the investment period. The required rate of return reflects the minimum return expected by investors for the level of risk associated with the investment. It is used as the discount rate to calculate the present value of future dividends. A constant discount rate simplifies the valuation process and ensures consistency in calculations. Changes in interest rates, market conditions, or business risk are not considered under this assumption. Therefore, the model works best when the required return remains relatively stable over time.

4. Growth Rate is Lower than the Required Rate of Return

The Dividend Discount Model assumes that the dividend growth rate is always lower than the required rate of return. This condition ensures that the mathematical formula produces a meaningful and positive share value. If the growth rate becomes equal to or greater than the required return, the model cannot calculate a valid intrinsic value. In practice, mature companies generally experience sustainable growth rates that remain below investors’ required returns. This assumption makes the model suitable for stable businesses with moderate long term growth rather than rapidly growing companies with highly uncertain future earnings and dividend patterns.

5. Efficient Capital Market

The Dividend Discount Model assumes that the capital market operates efficiently, meaning that investors have equal access to relevant information and securities are fairly priced based on available data. It also assumes that share prices eventually reflect the intrinsic value determined by expected future dividends. Although short term market prices may fluctuate due to investor sentiment or temporary factors, the model assumes that prices move toward their fair value over time. This assumption allows investors to compare the calculated intrinsic value with the current market price and identify undervalued or overvalued shares for investment decisions.