Introduction to DDM

To value a stock there exists several methods that are commonly used within the financial
industry. Generally, these methods identify future cash flows and to analyse historical
behaviour to predict future growth. The Dividend Discount Model (DDM) is a method that
values a stock based on the future cash flow to be received as dividend. The future cash
flows are discounted to calculate the present value, this value is discounted by a rate that is
dependent on the risk associated with the stock itself. The general formula to value a share
today is[1]:

n
0=
n=1 (1+ r e )n
P

Where n represents the dividends expected at year n, re represents the return of

equity. This is the most general form of the Dividend Discount Model. The difficulty
implementing this model is calculating the value of future dividend payments, it is
commonly assumed that dividends grow at a constant rate. This assumption does not lead
to the most accurate valuation of a stock. To account for this a refined model called the Two
Stage Dividend Discount Model is used [2]. This model assumed two stages of growth. The
first is a short term of varying growth rate followed by a long term constant growth rate. The
formula for this is[3]:

1 2 n 1 n+ 1
P 0=
(1+r e )
1
+
(1+r e )
2
+ n
( 1+ r e )
+ n
(
(1+r e ) ( r e g ) )
g represents the growth rate of the stock and the present value of future dividends are
calculated using this growth rate, it can take positive or negative values.
n +1 represents
the value of the dividends during the stable growth period. This is a better model than the
standard DDM as growth rate for new companies often fluctuates before it stabilises, this
often applies in times of economic uncertainty where fluctuations are expected before
stabilisation. The model can be extended further to what is commonly known as multi stage
DDM where there are multiple periods of varying growth followed by a long period of stable
growth, however, the two stage DDM provides an accurate enough method to evaluate the
value of a stock.

References

1. Berk J,DeMarzo P. Corporate Finance. 3rd ed.

2. NYU Stern. 2017. Available at:

http://pages.stern.nyu.edu/~adamodar/pdfiles/valn2ed/ch13.pdf.

3. Berk J,DeMarzo P. Corporate Finance. 3rd ed.