What is the dividend discount model?
The Dividend Discount Model (DDM) is a quantitative method for predicting a company’s stock price based on the theory that its current price is worth the sum of all its future dividend payments when discounted to its present value. It attempts to calculate the fair value of a stock regardless of current market conditions and takes into account dividend payment factors and market expected returns. If the value received from DDM is higher than the stock’s current trading price, the stock is undervalued and eligible to buy, and vice versa.
Learn about DDM
Companies produce goods or provide services for profit. The cash flow from such business activities determines its profits, which is reflected in the company’s share price. Companies also pay dividends to shareholders, which usually come from business profits. The DDM model is based on the theory that the value of a company is the present value of the sum of all its future dividend payments.
time value of money
Imagine you gave your friend $100 as an interest-free loan. After a while, you go to him to get your borrowed money. Your friend gave you two options:
- Take your $100 now
- Take your $100 after a year
Most people will choose the first choice. Withdrawing money now will allow you to deposit it in the bank. If the bank pays nominal interest, say 5%, your funds will grow to $105 after one year. That would be better than the second option of getting $100 from a friend a year later. Mathematically,