What you will learn
- Explain what the dividend discount model values and why
- Use the Gordon growth formula to value a dividend-paying stock
- Describe the kind of company the model fits best
- Recognize the model's limits, especially when growth approaches the required return
The dividend discount model is a focused version of the discounted cash flow idea. Instead of valuing all the free cash flow a business generates, it values a stock as the present value of the dividends it is expected to pay shareholders over time. For the right kind of company, it is clean and direct, and it uses the dividends you learned about in Unit 1.
The dividend growth model, with examples (Counttuts)
Works through the Gordon growth formula with numbers. Watch the examples, then try the calculation below yourself.
The premise
If you buy a share purely for the income it produces, then what you really own is a stream of future dividend payments. The dividend discount model takes this literally. The value of the stock is the sum of all expected future dividends, each discounted back to the present using the return you require. It is the same discounting logic as a full DCF, applied specifically to the cash paid out to shareholders rather than the cash generated by the whole firm.
Key terms
- Dividend discount model (DDM)
- Valuing a stock as the present value of its expected future dividends.
- Gordon growth model
- The constant-growth version of the DDM: value equals D1 divided by (r minus g).
- Required return (r)
- The annual return an investor demands for holding the stock.
- Dividend growth rate (g)
- The steady rate at which dividends are assumed to grow forever.
The Gordon growth version
The most common form is the constant growth dividend discount model, also called the Gordon growth model, which assumes dividends grow at a steady rate forever. In that case the value of the stock equals next year's expected dividend divided by the difference between the required return and the growth rate. In symbols, value equals D1 divided by (r minus g), where D1 is next year's dividend, r is the required return, and g is the constant growth rate. You may notice this is the same form as the perpetuity growth terminal value, because both value a growing perpetual stream.
Valuing a dividend stock
A stable utility is expected to pay a dividend of 2 dollars next year. You require a 8 percent return, and you expect the dividend to grow 3 percent per year forever. What is the stock worth?
- Write the formula. Value equals D1 divided by (r minus g).
- Plug in. 2 divided by (0.08 minus 0.03), which is 2 divided by 0.05.
- Solve. 2 divided by 0.05 is 40.
Why it matters: The value depends on the small gap between r and g. Because that gap is small, tiny changes in either input move the answer a lot.
Value a stock with the Gordon growth model
A company will pay a 3 dollar dividend next year. You require a 10 percent return and expect dividends to grow 4 percent forever. What is the stock worth per share?
For a stable dividend payer, a share is just a growing stream of future dividends, and the model prices that stream directly.
Where it fits best
The dividend discount model works best for mature, stable companies that pay regular, predictable, and steadily growing dividends, such as established utilities and consumer staples businesses. For these companies, dividends are a meaningful and reliable reflection of the value being returned to shareholders, so valuing the dividend stream is a sensible stand-in for valuing the stock.
The Gordon growth model formula explained (Brian Kehm)
A second short walkthrough of the D1 over (r minus g) formula. Watch for why the required return must exceed the growth rate.
The limitations
- It is useless for companies that pay no dividends, including many growth companies that reinvest all their earnings. For those, a free-cash-flow DCF is the right tool.
- It is extremely sensitive to the growth rate and required return, because the value depends on the small gap between them. Tiny changes in either swing the result wildly.
- The required return must be greater than the growth rate for the formula to make sense. If g approaches or exceeds r, the model breaks down and gives meaningless or infinite values.
- It assumes a smoothness and predictability of dividends that many companies simply do not have.
When the model breaks
An analyst uses the Gordon growth model with a required return of 8 percent and an assumed perpetual dividend growth rate of 9 percent. What happens, and why?
If the growth rate meets or exceeds the required return, r minus g is zero or negative and the formula breaks down. The Gordon growth model only works when r is greater than g.Right tool, right company
The dividend discount model fits some companies and not others. Name one type of company it suits well and one it does not, and explain why in a sentence or two. What is the general lesson about matching a method to a company?
Write an answer before comparing it with the model response.
Model answer
The DDM fits a mature utility or consumer staples company that pays steady, predictable, growing dividends, because valuing that reliable dividend stream is a fair stand-in for the stock. It does not fit a fast-growing tech company that pays no dividends, because there is nothing to discount, so a free-cash-flow DCF is needed instead. The general lesson is that a core valuation skill is choosing the method that matches the company in front of you.
The dividend discount model shows how discounting can be specialized to one kind of cash flow. Next we step back from formulas to the two great investing philosophies that shape how people hunt for value: growth and value investing.