Dividend Discount Model - DDM

Well, it's a technique used to value companies. Or at least it was…in the stone age. The 50s, maybe.

It basically says that a company’s value is fully contained in the cash dividends it distributes back to investors.

This model is only useful for its historical relevance. Back in the old-timey caveman days, when there was essentially no research of real merit being done on the performance of investments of whatever flavor, the dividend discount model was the best thing investors had to value and investment in a company.

And remember: in those days, companies paid real dividends that were a meaningful percentage of the total value of the company.

Example:

A company pays a dollar a share this year in dividends. Historically, it has raised dividends at 3% a year. The dividend discount model discounts back to present value. A few odd things are worth noting in this horse-and-buggy-era formula. The Dividend Discount Model ignores the terminal, or end value, of the company. Like...say 20 years from now, the company is sold. The dividends are all that are really focused on. Seem strange? Well, maybe...but let’s say the discount rate is 10%, and the risk-free rate is 4%, for a total of 14% a year discounted back to the present. Doing the math, just looking at the terminal value of, say, $100M in a sale to be made 20 years from now, you take 1.14, put it to the 20th power to reflect 20 years of discounted valuation…and you say 1.14 to the 20th power is about 13.7. So to get the present value of $100M 20 years from now using this discount rate, you would divide the $100M by 13.7…and that means that the $100M is roughly $7.3M of value today.

Yeah, that’s a big haircut.

The formula focuses a lot on near-term dividend distribution, and it’s really more interesting as a relic of original financial research than anything directly useful today.

And if you find this interesting, then...we may have a gig for you here at Shmoop Finance Central.