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The discounted dividend model or dividend discount model (DDM) is a financial method of stock analysis in which the future value of dividends issued by the underlying company is converted to a net present value. If the net present value supersedes the current stock price, investors consider the stock undervalued and, therefore, an attractive investment for growth income. A net present value that falls below the current price indicates an overvalued stock that will adjust downward in price in the future. The basic formula for the discounted dividend model for a no-growth company is P = Div/r, where P is the current value estimate, Div is the current dividend that the company pays, and r is the discount rate or rate of return. As a matter of necessity, the formula for the discounted dividend model only applies to stock of companies that offer dividends.
For example, Company X issues $0.75 US Dollars (USD) in dividends. The required rate of return for other types of investments is about six percent. Assuming the company is not a growth company, the present value price is calculated by dividing 0.75 USD by 0.06, yielding a value of $12.50 USD per share. If the current stock price for Company X stock is $11.00 USD, the stock, hence undervalued, can prove to be a worthwhile investment. On the other hand, if the stock is currently selling at $13.00 USD, it is overvalued.
For growth stock, the investor should modify the formula for discounted dividend model by changing the denominator of the formula to r - g, where r is the discount rate and g, the assumed growth rate. An investor may estimate a future growth rate based on the past track record of the company, the growth rate of the company's industry, or other known variables of the company, such as the impending launch of a new product. If the investor in Company X assumes a growth rate of two percent, the present value price is calculated by subtracting 0.02 from 0.06 and dividing 0.75 by the result. By using this growth modification in the dividend discount model, also called the Gordon model, an investor would see that the current value of the stock is 18.75, when considering the anticipated growth of the company. The Gordon model, however, assumes a constant dividend over time and a constant rate of business growth.
Detractors of the discounted dividend model point out that DDM relies on a fair amount of speculation. Dividends may not be fixed, and companies may grow at varying rates. Another problem with the formula is the establishment of the expected rate of return or discount rate, which may also vary over time. High rates of growth that exceed the expected interest rates also invalidate the formula, since no stock has a negative value. The dividend discount model does reinforce the foundational tenet that a company's value derives from its future cash flows, but its shortcomings point out the need for investors to use a variety of financial tools to assess security investments.
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