The dividend discount model (DDM) is used by investors to measure the value of a stock. It is similar to the discounted cash flow (DCF) valuation method; the difference is that DDM focuses on dividends while the DCF focuses on cash flow.
The DDM is not practically inapplicable for stocks that do not issue dividends or for stock with a high growth rate.
The DDM assumes that dividends are the relevant cash flows, comparable to coupon payments from a bond.
For the DCF, an investment is valued based on its future cash flows. DCF analysis assesses the value of a company today based on projections of how much money it will generate in the future. A DCF analysis uses a discount rate to find the present value of a stock. If the value calculated through DCF is higher than the current cost of the investment, the investor will consider the stock an opportunity.
For the DDM, future dividends are worth less because of the time value of money. Investors use the DDM to price stocks based on the sum of future income flows from dividends using the risk-adjusted required rate of return.
Investors can use the dividend discount model (DDM) for stocks that have just been issued or that have traded on the secondary market for years. There are two circumstances when DDM is practically inapplicable: when the stock does not issue dividends, and when the stock has an unusually high growth rate.
Each common share of a company represents an equity claim on the issuing corporation’s future cash flows. Investors can reasonably assume that the present value of a common stock is the present value of expected future cash flows. This is the basic premise of DCF analysis.
The DDM assumes that dividends are the relevant cash flows. Dividends represent income received without loss of asset (selling the stock for capital gains) and are comparable to coupon payments from a bond.
Although DDM advocates believe that, sooner or later, all firms will pay dividends on their common stock, the model is much more difficult to use without a benchmark dividend history.
The formula for using DDM is most prevalent when the issuing corporation has a track record of dividend payments. It’s incredibly difficult to forecast when, and to what extent, a non-dividend paying firm will begin distributing dividends to shareholders.
Controlling shareholders have a much stronger sense of control over other forms of cash flow so that the DCF method might be more appropriate for them.
A stock that grows too quickly will end up distorting the basic Gordon-Growth DDM formula, possibly even creating a negative denominator and causing a stock’s value to read negative. Other DDM methods may help to mitigate this problem.