Meaning Of Dividend Discount Model:
The Dividend Discount Model, also known as the DDM, is a method of calculating a stock's price based on the likelihood that dividends will be paid in the future, and then discounting those dividends at the expected yearly rate. In layman's terms, it is a method of determining the worth of a company that is based on the theory that a stock is worth the discounted sum of all of the company's future dividend payments. In other words, it is used to determine the value of a stock based on the net present value of future dividends.
Breaking Down the Dividend Discount Model
This model was developed on the assumption that the intrinsic value of a stock reflects the present value of all future cash flows generated by a security at the time of its creation. Dividend payments are essentially the positive cash flows generated by a company and distributed to its shareholders at the same time.
Overall, the dividend discount model is a straightforward method of calculating an appropriate stock price from a mathematical standpoint with the bare minimum of input variables required. The model, on the other hand, is based on a number of assumptions that are difficult to predict.
As the dividend discount model varies from one variation to another, a financial analyst is required to predict future dividend payments as well as the growth in dividend payments as well as the cost of equity capital. It is nearly impossible to predict all of the variables with precision. As a result, in many instances, the theoretically fair stock price differs significantly from the actual price.
Types of Dividend Discount Model
1) Zero Growth Dividend Discount Model
This model assumes that the dividend will always remain constant, i.e., that there will be no increase in dividends over the years. Consequently, the stock price would be calculated as follows: annual dividends divided by the required rate of return = stock price
Stock’s Intrinsic Value = Annual Dividends / Required Rate of Return
This is essentially the same formula that is used to calculate the Present Value of Perpetuity, and it can be used to price preferred stock, which pays a dividend equal to a specified percentage of its par value and pays a dividend equal to a specified percentage of its par value. Even if a stock is based on the zero-growth model, its price can change if the required rate changes as a result of changes in perceived risk, as an example.
2) Constant-Growth Rate DDM Model
The constant-growth The Dividend Discount Model, also known as the Gordon Growth Model, is based on the assumption that dividends grow by a specific percentage each year. Dividend growth rates are generally denoted by the letter g, and the required rate is denoted by the letter Ke. Another important assumption to keep in mind is that the required rate, abbreviated as Ke, remains constant from one year to the next.
Growth that is unabated The Dividend Discount Model, also known as the DDM Model, calculates the present value of an infinite stream of dividends that is growing at a constant rate over time.
3) Variable-Growth Rate DDM Model (Multi-stage Dividend Discount Model)
Growth at a variable rate When compared to the other two types of dividend discount models, the Dividend Discount Model, also known as the DDM Model, is much more realistic. Using the assumption that the company will go through different growth phases, this model is able to solve the problems associated with unsteady dividends.
Variable growth rates can manifest themselves in a variety of ways; you can even assume that the growth rates are different from one year to the next. The most common form, on the other hand, is one that assumes three different rates of growth. An initial high rate of growth, a transition to slower growth, and a sustainable steady rate of growth.
The constant-growth rate model is first and foremost extended, with each phase of growth calculated using the constant-growth method, but with different growth rates for the various phases. The total of the present values of each stage is used to calculate the intrinsic value of the company's stock.
Pros and Cons
1. Simplicity of Calculations
As long as investors understand the model's variables, calculating the value of a single share of stock is a straightforward process. Calculating the price of a stock only requires a small amount of algebra.
2. Sound and Logical Basis for the Model
A fundamental assumption of the model is that investors purchase stocks in order to receive a payment at a later date. Despite the fact that investors may purchase a security for a variety of reasons, this is an appropriate basis for doing so. Even if investors never received a payment for their investment, the security would be worthless to them.
3. The Process Can Be Reversed to Determine Growth Rates Experts Predicted
Once investors have determined the current price of a share of stock, they can reorder the process in order to determine the dividend growth rates that are expected for the company. It's useful if they already know what the predicted value of a share of stock is, but they want to know how much money they can expect to receive in dividends.
1. Difficulty Determining the Variables that Go into the Model
The dividend discount model is easy to understand and apply. However, determining the numbers that go into it can be difficult, which can lead to inaccurate results in some cases. Due to the fact that dividends paid by companies are frequently unpredictable, forecasting them for this model is difficult. It is also extremely difficult to forecast a company's future sales, which has an impact on the ability of a corporation to maintain or increase dividends.
2. Investor Bias Model
In general, investors have a proclivity to confirm their own predictions. As a result, because many of the inputs are somewhat subjective, the majority of investors will arrive at their own valuations for a given stock. Only those who are able to force themselves to be objective will be able to come up with accurate variables for the simulation.
3. Sensitive Valuation Model
This model is extremely sensitive to even the smallest changes in its input parameters. As a result, if you are slightly off with your estimate of specific input, it can be easy to mistakenly identify a security as being overpriced or underpriced.