There has been much said about investing and how to accurately value a particular stock or other asset. Plenty of theories exist as to how to determine the real value of an investment today. There are few models as popular as the dividend discount model (DDM) though, and this alone warrants a review of the pros and cons of the DDM.
How This Model Works
In order to make an assessment of the value of DDM you must first understand how it works. It sounds complicated at first, but truthfully it is just a mathematical equation that is supposed to produce a result for the value of a stock. Basically, one must first select a company that pays a dividend and also choose how much of a return they would like to see from that investment.
Ten percent per year is a benchmark used by a lot of people when it comes to investing. That is a pretty good and realistic goal to have. Assuming that is what you are shooting for the DDM works like this: Price equals dividends divided by rate of return minus dividend growth rate.
Price = Dividends / (Rate of Return – Dividend Growth Rate)
The purpose of using this model is to give accurate value to the stock based on what it pays out as a dividend. There are some assumptions that one must plug in to the model to make it work, but once those assumptions are plugged in all of the guesswork is done. The model will just churn out a number for what the price of the stock should be and you are on your way.
Why You Should Love This Model
There are some simple but great reasons to love the dividend discount model. Among all of the ways to value stocks it is a favorite for a variety of reasons.
Highly Conservative – This model does not try to make wild assumptions about the growth of a stock into the future because the dividend growth rate can’t be more than the rate of return for the formula to work. All it is doing is making a judgement based on what the dividend that is paid out today is and assuming that the dividend will grow at a non-outrageous level in the future. If the underlying stock actually returns more money in the form of growth then that is just a bonus on top of everything else.
