Dividend Discount Model

The Dividend Discount Model is a stock valuation tool that is supposed to provide an investor with a quick way to evaluate if a stock is overvalued or not. Basically, it states that the value of a stock is all of its future cash flows (dividends) discounted by some rate of return that is usually risk adjusted. If you just said to yourself – what the heck does that mean don’t worry.

The quick and dirty formula for calculating the value of a stock using this model is:

Value of Stock = Dividend per share / (Discount Rate – Dividend Growth Rate)

The problem with using the DDM is that one must make some assumptions and these assumptions are pretty much impossible to predict. I guess that is like all stock valuation methods – if an investor just uses P/E for example then they must make some sort of guess what the P/E will do in the future to decide if the stock is cheap or not. Basically the DDM can be used as a jumping off point for more analysis on a stock. If the DDM shows the stock is undervalued, then dig in and find out why. If the DDM shows that it is overvalued, then dig in deeper to see if that is in fact the case. There may be things like brand and other intangibles that need to be factored into the equation.