• Invest
    Investment Suite
    Stocks
    Mutual Funds
    Future and Options
    IPO
    Exchange Traded Funds
    Commodity
    Stockcase (Stock Baskets)
    Currency
    Non Convertible Debentures
    Sovereign Gold Bond
    Exclusive
    NRI Account
    Private Client Group
    Features
    SipIt
    MTF
    Investment Suite
    Exclusive
    Features
  • Platform
    Product Suite
    Kotak Neo App & Web
    Nest Trading Terminal
    NEO Trade APIs
    Features and Tools
    MTF
    Securities Accepted as Collateral
    Margin Requirements
    Equity Screeners
    Payoff Analyzer
    Calculators
    SIP Calculator
    Lumpsum Calculator
    Brokerage Calculator
    Margin Calculator
    MTF Calculator
    SWP Calculator
    CAGR Calculator
    Simple Interest Calculator
    ELSS Calculator
    Step up SIP Calculator
    All Calculators
    Product Suite
    Features and Tools
    Calculators
  • Pricing
  • Research
    Research Calls
    Long Term calls
    Short Term calls
    Intraday calls
    Derivatives calls
    Pick of the week
    Top Monthly Picks
    Research Reports
    Fundamental Research Report
    Technical Research Report
    Derivative Research Report
    Research Calls
    Research Reports
  • Market
    Stocks
    Market Movers
    Large Cap
    Mid Cap
    Small Cap
    Indices
    Nifty 50
    Bank Nifty
    FinNifty
    Nifty Midcap India
    VIX
    All Indian Indices
    Mutual Funds
    SBI Mutual Funds
    HDFC Mutual Funds
    Axis Mutual Funds
    ICICI Prudential Mutual Funds
    Nippon India Mutual Funds
    All AMC's
    IPO
    Upcoming IPO
    Current IPO
    Closed IPO
    Recently Listed IPO
    Stocks
    Indices
    Mutual Funds
    IPO
  • Learn
    Resource
    Market Ready
    Kotak Insights
    Infographic
    Podcast
    Webinars
    Youtube Channel
    Quarterly Results
    Investing Guide
    Demat Account
    Trading Account
    Share Market
    Intraday Trading
    IPO
    Mutual Funds
    Commodities
    Currency
    Futures & Options
    Derivatives
    Margin Trading
    Events
    Budget 2024
    Muhurat Trading
    Share Market Holiday
    Market Outlook 2025
    Resource
    Investing Guide
    Events
  • Partner
    Business Associates
    Fund Expert
    Kotak Connect Plus
    Startup connect
  • Support
    FAQs
    Circulars
    Bulletins
    Contact Us
    Forms Download
    Get your Statement

What is the Dividend Discount Model?

  •  4 min read
  • 0
  • 20 Dec 2023
What is the Dividend Discount Model?

Key Highlights

  • The Dividend Discount Model (DDM) is a conservative method for valuing stocks. It determines a stock's worth by considering the present value of its anticipated future dividends.
  • Different types of DDM include Zero Growth DDM, Gordon Growth DDM (constant growth), Two-Stage DDM, and Three-Stage DDM.
  • The model has limitations, such as its reliance on dividend payouts, making it unsuitable for evaluating stocks that don't pay dividends.

The Dividend Discount Model (DDM) is widely accepted as one of the most conservative methods to value stocks. In the Dividend Discount Model, a stock is worth its price if its present value exceeds the estimated net present value of future dividends.

It is based on many assumptions, such as future dividend payments, growth patterns, and interest rate trends. Using DDM, stocks are valued based on their net present value of dividends to come. Stock values are calculated by taking the sum of the future cash flows the firm expects to generate, and discounting them by a risk-adjusted rate. The dividends can be used to determine how much cash is returned to shareholders.

Under the dividend discount model (DDM), the implied stock price is calculated as follows. Intrinsic Value Per Share = D1 ÷ (ke - g) Where: D1 = Expected Dividend in Next Year ke = Cost of Equity g = Growth Rate of Dividend

Here are the different types of DDM:

1. Zero Growth Dividend discount models assume that the dividend growth rate (DGR) remains constant throughout perpetuity, and the share price equals the annualised dividend divided by the discount rate.

2. Gordon Growth DDM It is often called the constant growth DDM. This variation assigns a perpetual DGR with no change throughout the entire period of the forecast.

3. Two-Stage DDM DDMs determine the share price of a company based on a two-stage forecast: an initial period of increasing dividend growth, followed by a stable dividend growth period.

4. Three-Stage DDM DDM's three-stage variation is an extension of two-stage DDM, with dividend growth rates declining over time.

The Dividend Discount Model has a few drawbacks. Here are they:

1. Dividend Payouts Necessity The first and foremost disadvantage of DDM is that it cannot be used to evaluate stocks that don't pay dividends despite capital gains that would be realised from investing in them. DDMs assume that the only value of a stock lies in its return on investment (ROI) through dividends. When assessing a number of companies, the DDM model is useless because it only works when dividends are expected to rise consistently in the future. Only fairly mature companies with dividend payment histories can be used with it.

2. Too Many Assumptions As discussed in this article, the Dividend Discount Model makes too many assumptions about dividends. These include assumptions about growth rates, interest rates, and tax rates, all of which are beyond the investor's control. A drawback like this reduces the DDM model's reliability.

3. Buyback Ignorance In addition, the DDM does not take stock buybacks into account. The stock valuation of a company changes when the company buys back shares from its shareholders. DDM is too conservative and does not account for stock buybacks, especially in countries with tax structures that make share buybacks more advantageous than dividends.

Conclusion

By comparing investments across different sectors, dividend discount models can help investors pick stocks that are overbought or oversold. It is best used for stocks with a long dividend history. However, not for stocks with a short or no dividend history. Furthermore, it is important to evaluate a variety of factors before making a final decision on any investment.

FAQs on the Dividend Discount Model

Dividend discount models have a few downsides, including their lack of accuracy. A major limitation of the DDM is that it can only be used with dividend-paying companies. Additionally, the DDM does not consider stock buybacks, which makes it too conservative.

Using the Dividend Discount Model, an investor can evaluate several assumptions about a company's growth and future prospects. The DDM shows that a company's value is determined by its total future cash flows discounted to its present value.

In the DDM, the fair value of a stock is calculated regardless of current market conditions. If the DDM value is greater than the current stock price, then the stock is undervalued and should be purchased. The opposite is true if the DDM value is lower.

Did you enjoy this article?

0 people liked this article.

What could we have done to make this article better?

Enjoy Free Demat Account Opening
+91 -

personImage
Enjoy Free Demat Account Opening
+91 -

N
N
[object Object]
[object Object]
[object Object]
[object Object]
[object Object]
[object Object]
[object Object]
[object Object]
[object Object]
[object Object]
[object Object]
[object Object]
[object Object]
[object Object]
[object Object]
[object Object]
[object Object]
[object Object]
[object Object]
[object Object]
[object Object]
[object Object]