Investments
Dividend discount model
The dividend discount model values a share as the present value of its future dividends.
Definition
The dividend discount model values equity from the cash the shareholder actually receives. In its simplest form, the Gordon growth model assumes dividends grow at a constant rate forever and values the share as next year's dividend divided by the required return minus growth.
The model is most defensible for mature, stable dividend payers. It becomes extremely sensitive to the growth assumption as growth approaches the required return.
Intuition
A share is worth the dividends it will pay, discounted to today. Growth raises every future dividend; the required return discounts them.
When to use it
- Valuing mature, stable dividend-paying companies.
- Screening whether a market price implies plausible growth and required return.
When not to use it
- Companies that pay no dividend, or growth above the required return (the formula breaks down).
Formula
Gordon growth model
P0 = D1 ÷ (r − g)
Values a share with dividends growing at a constant rate.
- D1
- Next year's dividend, D0 × (1 + g)
- r
- Required return
- g
- Constant perpetual growth rate
Worked example
Value from a constant dividend
Current dividend 2.00; growth 5%; required return 10%.
- 1
Next dividend
D1 = 2.00 × 1.05 = 2.10.
- 2
Spread
r − g = 10% − 5% = 5%.
- 3
Value
2.10 ÷ 0.05 = 42.00.
The model values the share at 42.00 per share.
Common mistakes
- Using the current dividend D0 instead of next year's D1.
- Assuming a perpetual growth rate above long-run GDP growth.
- Ignoring that a tiny change in g moves the value enormously.
How it connects
is an advanced form of
The source extends the target once the basics are secure.
contrasts with
Often confused, but different in an important way.
- Bond pricing and yield: Equity promises grow; bond promises are contractual.
is used in
The source appears as an input to the target.
- CAPM and beta: CAPM supplies the required return in the discount rate.
relates to
Useful to study together, in either order.