dividend discount model

The model uses the fact that the current value of the dividend payment $D\_0\; (1+g)^t$ at (discrete) time $t$ is $\backslash frac\{D\_0\; (1+g)^t\}\{\{(1+r)\}^t\}$, and so the current value of all the future dividend payments, which is the current price $P$, is the sum of the infinite series

: $P\_0=\; \backslash sum\_\{t=1\}^\{\backslash infty\}\; \{D\_0\}\; \backslash frac\{(1+g)^\{t\}\}\{(1+r)^t\}$

This summation can be rewritten as

:$P\_0=\{D\_0\}\; r\text{'}\; (1+r\text{'}+\{r\text{'}\}^2+\{r\text{'}\}^3+....)$

where

:$r\text{'}=\backslash frac\{1+g\}\{1+r\}.$

The series in parentheses is the geometric series with common ratio $r\text{'}$ so it sums to $\backslash frac\{1\}\{1-r\text{'}\}$ if . Thus,

: $P\_0\; =\; \backslash frac\{D\_0\; r\text{'}\}\{1-r\text{'}\}$

Substituting the value for $r\text{'}$ leads to

: $P\_0\; =\; \backslash frac\{D\_0\; \backslash frac\{1+g\}\{1+r\}\}\{1-\backslash frac\{1+g\}\{1+r\}\}$,

which is simplified by multiplying by $\backslash frac\; \{1+r\}\{1+r\}$, so that

:$P\_0\; =\; \backslash frac\{D\_0(1+g)\}\{r-g\}\; =\; \backslash frac\{D\_1\}\{r-g\}$

The DDM equation can also be understood to state simply that a stock's total return equals the sum of its income and capital gains.

:$\backslash frac\{D\_1\}\{r\; -g\}\; =\; P\_0$ is rearranged to give $\backslash frac\{D\_1\}\{P\_0\}\; +\; g\; =\; r$

So the dividend yield $(D\_1/P\_0)$ plus the growth $(g)$ equals cost of equity $(r)$.

Consider the dividend growth rate in the DDM model as a proxy for the growth of earnings and by extension the stock price and capital gains. Consider the DDM's cost of equity capital as a proxy for the investor's required total return.{{Cite web |url=http://www.retailinvestor.org/perpetuity.xls |title=Spreadsheet for variable inputs to Gordon Model |access-date=2011-12-28 |archive-date=2019-03-22 |archive-url=https://web.archive.org/web/20190322151033/http://www.retailinvestor.org/perpetuity.xls |url-status=dead }}

:$\backslash text\{Income\}\; +\; \backslash text\{Capital\; Gain\}\; =\; \backslash text\{Total\; Return\}$

From the first equation, one might notice that $r-g$ cannot be negative. When growth is expected to exceed the cost of equity in the short run, then usually a two-stage DDM is used:

:$P\; =\; \backslash sum\_\{t=1\}^N\; \backslash frac\{D\_0\; \backslash left(\; 1+g\; \backslash right)^t\}\{\backslash left(\; 1+r\backslash right)^t\}\; +\; \backslash frac\{P\_N\}\{\backslash left(\; 1\; +r\backslash right)^N\}$

Therefore,

:$P\; =\; \backslash frac\{D\_0\; \backslash left(\; 1\; +\; g\; \backslash right)\}\{r-g\}\; \backslash left[\; 1-\; \backslash frac\{\backslash left(\; 1+g\; \backslash right)^N\}\{\backslash left(\; 1\; +\; r\; \backslash right)^N\}\; \backslash right]$

+ \frac{D_0 \left( 1 + g \right)^N \left( 1 + g_\infty \right)}{\left( 1 + r \right)^N \left( r - g_\infty \right)},

where $g$ denotes the short-run expected growth rate, $g\_\backslash infty$ denotes the long-run growth rate, and $N$ is the period (number of years), over which the short-run growth rate is applied.

Even when g is very close to r, P approaches infinity, so the model becomes meaningless.

a)

When the growth g is zero, the dividend is capitalized.

:$P\_0\; =\; \backslash frac\{D\_1\}\{r\}$.

b)

This equation is also used to estimate the cost of capital by solving for $r$.

:$r\; =\; \backslash frac\{D\_1\}\{P\_0\}\; +\; g.$

c)

which is equivalent to the formula of the Gordon Growth Model (or Yield-plus-growth Model):

:$P\_0$ = $\backslash frac\{D\_1\}\{k\; -\; g\}$

where “$P\_0$” stands for the present stock value, “$D\_1$” stands for expected dividend per share one year from the present time, “g” stands for rate of growth of dividends, and “k” represents the required return rate for the equity investor.

The following shortcomings have been noted;{{Citation needed|date=November 2020}}

See also {{section link|Discounted cash flow#Shortcomings}}.

1. The presumption of a steady and perpetual growth rate less than the cost of capital may not be reasonable.
2. If the stock does not currently pay a dividend, like many growth stocks, more general versions of the discounted dividend model must be used to value the stock. One common technique is to assume that the Modigliani–Miller hypothesis of dividend irrelevance is true, and therefore replace the stock's dividend D with E earnings per share. However, this requires the use of earnings growth rather than dividend growth, which might be different. This approach is especially useful for computing the residual value of future periods.
3. The stock price resulting from the Gordon model is sensitive to the growth rate $g$ chosen; see {{section link|Sustainable growth rate#From a financial perspective}}

The dividend discount model does not include projected cash flow from the sale of the stock at the end of the investment time horizon. A related approach, known as a discounted cash flow analysis, can be used to calculate the intrinsic value of a stock including both expected future dividends and the expected sale price at the end of the holding period. If the intrinsic value exceeds the stock’s current market price, the stock is an attractive investment.{{cite book |last1=Bodie, Zvi; Kane, Alex; Marcus, Alla |title=Essentials of Investments |date=2010 |publisher=McGraw-Hill Irwin |location=New York NY |isbn=978-0-07-338240-1 |pages=397-400 |edition=eighth}}

{{reflist}}

• {{cite book |title=The Investment, Financing, and Valuation of the Corporation |last=Gordon |first=Myron J. |year=1962 |publisher=R. D. Irwin |location=Homewood, IL |url=https://archive.org/details/investmentfinanc0000gord|url-access=registration }}
• {{cite web|title=Equity Discounted Cash Flow Models|url=http://pages.stern.nyu.edu/~adamodar/pdfiles/damodaran2ed/ch5.pdf|url-status=dead|archive-url=https://web.archive.org/web/20130612035830/http://pages.stern.nyu.edu/~adamodar/pdfiles/damodaran2ed/ch5.pdf|archive-date=2013-06-12}}
• {{cite book |title=Essentials of Investments, tenth edition |last=Bodie, Zvi; Kane, Alex; and Marcus, Alan J. |year=2010 |publisher=McGraw-Hill Irwin |location=New York, NY|url=http://students.aiu.edu/submissions/profiles/resources/onlineBook/H3L9c4_Essentials-inv.pdf }}

• [https://ssrn.com/abstract=996016 Alternative derivations of the Gordon Model and its place in the context of other DCF-based shortcuts]

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