What is Dividend Discount Model?
The dividend discount model is a method used for predicting the price of a company's stock based on the theory that its present-day price is worth the sum of all of its future dividend payments when discounted back to their present value. If the value obtained from the DDM is higher than the current trading price of shares, then the stock is undervalued and qualifies for a buy.
The formula of Dividend Discount Model is:
Value of stock = Expected dividend share / (cost of capital equity + dividend growth rate)
Since the variables used in the formula include the dividend per share, the net discount rate (represented by the required rate of return or cost of equity and the expected rate of dividend growth), it comes with certain assumptions. Since dividends, and its growth rate, are key inputs to the formula, the DDM is believed to be applicable only on companies that pay out regular dividends