Dividend Discount Model (DDM) Calculator

Calculate the fair value of a stock balancing the dividend payout factors and the market expected returns. The DDM Calculator excludes prevailing market conditions.

Dividend Discount Model (DDM): A measure to calculate the fair value of a stock

Dividend discount model (DDM) is based on a theory that the current value of a company's stock is the sum of all its future dividend payments when discounted back to their present value. This method is used to predict the present value of a company's stock.

This model is also known as Gordon Growth Model (GGM). It is named after Myron J. Gordon of the University of Toronto. He first published it with Eli Shapiro in 1956.

As per the model, the stock may be considered for buying if the current value obtained by DDM is higher than the current price of shares. This is because it will show that the stock is undervalued and has a potential to give good returns on investment.

How to Calculate Dividend Discount Model (DDM)

The DDM is one of the oldest methods of valuing the stocks. DDM is calculated using the following formula:

Where

• Present value of stock - This refers to how much the stock is currently worth.
• Expected Dividend - The amount of cash received in the next dividend period.
• Cost of equity - The percentage of minimum rate of return that investors require at the time of purchasing any stocks.
• Expected growth rate of dividends - This is also a percentage of the growth rate that is expected on the dividend for a particular period.

Using DDM for investments

DDM excludes the prevailing market conditions, which makes it quite popular. It also helps in making direct comparisons among companies, even if they belong to different working sectors.

It majorly depends on what investors actually believe to be the present value of a stock. If they believe that it is the sum of discounted values of future dividends paid to them, they may use it for identifying overbought or oversold stocks.

Drawbacks of using DDM

DDM is a widely used method for valuing stocks. However, there are a few shortcomings that one may face while using this model:

Sensitivity to inputs

The results provided by DDM are very sensitive to inputs. This means if there is a certain percentage decrease in the dividend growth rate, it is possible that the results obtained using DDM might show a lot more percentage decrease in the stock price when compared to the value of decrease in the dividend growth rate.

Assumptions of dividend growth

This model assumes the constant dividend growth in perpetuity. This may be safe to assume in case of mature companies that have an established history pertaining to dividend payments. However, in the case of new companies the dividend growth may be fluctuating or perhaps have no dividends at all.

Dividend growth Vs. Rate of return

There are some companies that keep paying dividends even if they are making losses. The DDM also falls behind to give the correct results for these companies because the rate of return is lower than the dividend growth rate.

Dividend Discount Model (DDM) Calculator

The DDM calculator simplifies calculating different variables used to calculate the fair value of a company's stock.

• Dividend Payout Ratio - Stands for a fraction of a company's net income that is paid to its stockholders in dividends.
• Return on Equity - This means the percentage of net income of a company divided by total equity. This is generally calculated for a year.
• Dividend per share - This is the amount that is received by an investor per share as and when a company decides to distribute a part of its profits to its stockholders as dividends.
• Risk Free Rate - The risk free rate accounts for a theoretical rate of return on an investment that is assumed to have no risk involved. The risk free rate can be calculated by subtracting the current inflation rate during the period of your investment from yield of the treasury bond.
• Beta of stock - Beta is a measure of systematic risk involved with investing in a particular stock relative to the risk of the market. The beta of stock would be 1. An individual security with the beta of .5 would have less risk, whereas beta of stock 1.5 would be riskier than the market.
• Market Risk Premium - This is the difference between the expected return on the market portfolio and the risk free rate.

Once you enter all the above information into the calculator, you will have the DDM fair value of the stock in question. When used carefully with correct inputs, the DDM is a simple yet effective method of calculating stock value.