Table of contentsWhat is the dividend discount model?Dividend discount model formula (DDM formula)Constant growth dividend discount model explanationDividend discount model using CAPM - dividend discount model cost of equityHow to calculate DDM - Dividend discount model exampleFAQs
This dividend discount model calculator is a simple tool that lets you calculate stock value based on the dividend discount model formula (DDM formula for short). If you are new to the world of investing, head over to our dividend calculator for an introduction to dividends.
In this article, you will find a constant growth dividend discount model explanation as well as the dividend discount model using CAPM (Capital Asset Pricing Model). Lastly, we will give you a dividend discount model example and show you step by step how to calculate it.
What is the dividend discount model?
Dividend discount model is one of the numerous different methods of stock valuation. In this model, stock value is equal to the sum of all of the company's future dividend payments discounted back to their present value. The advantage of this approach is that it allows you to evaluate the value of a company regardless of its current stock price. Stock prices can be influenced by the current condition of the market, and may not accurately reflect the companies value.
Present value is closely tied to the concept of the time value of money - in short, it means that the value of money changes over time. This change is represented by a popular saying: "a dollar today is worth more than a dollar tomorrow". To read more about this concept check out our time value of money calculator.
On a side note, quite a lot of people search for a dividend discount model by typing the phrase "DDM model". This is curious because, as you already know, the "M" in the DDM abbreviation stands for the word "model". In fact, more people search for the phrase "DDM model" than for DDM formula.
If you are interested in the different ways a company can be valued, check out the discounted cash flow calculator.
Dividend discount model formula (DDM formula)
The most popular and widely used variant of the dividend discount model is the Gordon Growth Model or GGM for short, which is preferred due to its simplicity. The model calculates the present value of an infinite stream of future dividends, given an expected dividend that is paid for one year, with the assumption that the dividends grow at a constant rate in perpetuity. That is why the GGM is sometimes referred to as constant growth dividend discount model. The constant growth dividend discount model can be expressed with the following formula:
present stock value = expected dividend / (cost of equity - expected growth rate),
present stock valuerepresents how much the stock is currently worth;
expected dividendpayable in one year is the amount of cash received in the next dividend period;
cost of equityis a percentage that represents the minimum rate of return that investors require when buying stock; and
expected growth rate of dividendsis a constant. Just like the cost of equity, it is also a percentage value.
If you have these variables, enter them into the appropriate fields of the dividend discount model calculator. If not, don't be concerned, the next section will help you understand how to calculate them.
Constant growth dividend discount model explanation
In the previous section, we showed you the basic DDM formula and all of its variables. Now, you may only know a few of these variables, but still want to use the dividend discount model formula, so we'll show you how to calculate each field . Let's start with the expected growth rate of dividends. It can be determined as:
expected growth rate = (1 – dividend payout ratio) * return on equity,
dividend payout ratiois the fraction of the company's earnings paid to the shareholders in dividends, expressed as a percentage for easier use; and
return on equity, or ROE, is a popular business ratio that informs us how profitable a company is in generating profit from its equity.
Now that you have calculated the expected growth rate, you can move on to finding the value of the future dividends:
expected dividend = dividends per share * (1 + expected growth rate),
dividends per share is the current amount of dividends paid.
Dividend discount model using CAPM - dividend discount model cost of equity
The next step is to calculate the cost of equity. We have a great CAPM calculator that covers this topic. Without going into too much detail, the formula is:
cost of equity = risk-free rate + beta * market risk premium,
risk-free rateis the risk-free interest rate, typically taken as the yield on a long-term government bond in the country where the project is based;
betais market risk is a statistical measure of the variability of a company's stock price relative the stock market overall; and
market risk premiumis a measure of the return that investors require on top of the risk-free rate in order to compensate them for the risk of an investment that matches the volatility of the entire market. In other words:
market risk premium = market Rate of Return - risk-free rate of return.
Finally, we have now calculated all the components and can plug them in into the base formula. Congratulations! Now you know exactly how our dividend discount model calculator does its magic! There are also.
But how do you interpret the result? Well, as with all stock valuation methods, if the price of the stock calculated using this method is higher than the current market stock price, it means that the stock is undervalued and should be bought. The same is true in reverse, if DDM stock price is lower than the current market one, the stock is overvalued.
How to calculate DDM - Dividend discount model example
Oh, that was a lot of equations to take in. Let's go over everything step by step with one dividend discount model example. Let's assume the Company X has a dividend payout ratio of 6% and ROE of 4%. In this case, the expected growth rate would be equal to:
expected growth rate = (1 – 0.06) * 0.04 = 0.0376 = 3.76%.
Furthermore, the company currently pays $6 dividends, making the expected dividend:
expected dividend = $6 * (1 + 0.0376) = $6.2256.
Let's assume that in the imaginary country San Escobar, where Company X operates, the risk-free market rate is 3%, the market risk premium is 7%, and beta is 1. In the next step is to calculate the dividend discount model cost of equity:
cost of equity = 0.03 + 1 * 0.07 = 0.1 = 10%
Finally, this allows us to calculate the present value according to the dividend discount model:
present stock value = $6.2256 / (0.1 - 0.0376) ≈ $99.77,
Maybe you feel a little bit overwhelmed by all those calculations, or you value your time, and you don't want to spend whole afternoon scribbling numbers on a piece of paper. Either way, we can help you. Just enter the variables and our dividend discount model calculator will do the work for you.
As we mentioned before, there are many different methods of valuation. None of them are perfect, but each of them can be useful in certain situations. They measure different aspects of the business, make assumptions, and can produce different results. Think of them as each offering a different perspective on the business's well-being; useful alone, but together they show the bigger picture. Therefore, before making an investment decision, it is best to check the data using a wide range of equations.
What are the limitations of the Dividend Discount Model?
The Dividend Discount Model relies on several assumptions, such as a constant dividend growth rate, and may not be suitable for companies that do not pay dividends or have unpredictable dividend patterns. It also assumes that dividends are the only source of value for investors.
What are the key components of the Dividend Discount Model?
The key components of the DDM include the expected future dividends, the discount rate, and the assumed dividend growth rate.
What is the dividend growth rate if the ROE is 10%?
Assuming that the dividend payout ratio is
60%. The dividend growth rate is
4%. You can calculate this using this formula:
dividend growth rate = (1 - dividend payout ratio) × ROE.
How do I calculate the cost of equity?
You can calculate the cost of equity in 4 steps:
Determine the beta of the stock.
Understand the risk-free rate.
Compute the market risk premium.
Apply the CAPM formula:
cost of equity = risk-free rate + beta × market risk premium.
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