Dividend Discount Model (DDM)
Equity value as the present value of all future dividends, often via the Gordon growth formula.
Definition
The DDM values a stock as the present value of all future dividend payments. Its simplest form, the Gordon Growth Model, assumes dividends grow at a constant rate forever. DDM is appropriate for stable, dividend-paying mature businesses — utilities, telecoms, banks, blue-chip consumer staples — but not for growth companies that pay no dividend. A multi-stage DDM allows for different growth phases (high growth then mature). The model is exquisitely sensitive to the gap between cost of equity and growth rate.
Formula
Gordon Growth:
P0 = D1 / (Ke - g)
Multi-stage:
P0 = sum_{t=1..N} D_t / (1+Ke)^t + P_N / (1+Ke)^N
where:
D1 = next year dividend
Ke = cost of equity
g = perpetual growth rate (g < Ke)Worked example
A utility pays a $4 dividend, expected to grow at 3% forever. Cost of equity = 8%. Fair price = 4 / (0.08 - 0.03) = $80. If the stock currently trades at $70, the model implies 14% upside.
How ARIA Analyst uses it
ARIA runs a 2-stage DDM in the Income Agent for any stock with a multi-year dividend track record, and refuses to publish the result if g >= Ke (divergent model).
Related terms
Discounted Cash Flow (DCF)
Intrinsic value of an asset as the present value of its future cash flows.
P/E Ratio
Share price divided by earnings per share — the most popular valuation multiple.
Residual Income Model
Equity value as book value plus the present value of excess returns over cost of equity.
FCF Yield
Free cash flow per share divided by share price — the "earnings yield" of cash.
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