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Asian woman checking her investmentsStock pricing may play a part in determining which companies to add to your investment portfolio. The dividend discount model or DDM is a commonly used method for measuring valuations. This model bases value calculations on present and future dividend payouts rather than current market conditions. If you’re a value investor, you can use the dividend discount model to identify stocks that may be undervalued by the market. You can also use DDM to compare values for blue-chip stocks if you’re interested in adding larger companies to your portfolio.

Work with a financial advisor to find additional ways of generating passive income besides dividends.

Dividend Discount Model Explained

Dividends represent a percentage of profits that a company pays out to its shareholder. Some companies pay out 100% of dividends to shareholders, others may pay more or less. The dividend discount model revolves around a central concept for valuing stocks. Specifically, it’s based on the idea that a stock’s worth is equivalent to the dividends it generates now and in the future.

To apply the DDM, you have to assume that a stock’s current price is equal to all of the dividends the underlying company will pay out in the future, discounted back to their present value. In simple terms, the dividend discount model can tell you the value of a company based on its expected dividend growth.

The dividend discount model doesn’t require current stock market conditions to be considered when finding the value of a stock. Again, the emphasis is on future dividend growth. For that reason, DDM isn’t necessarily a 100% accurate way to measure the value of a company. But it can still be useful for evaluating companies when deciding where to invest.

How Is Dividend Discount Model Calculated?

There’s more than one formula you can use to apply the dividend discount model to estimate a company’s value. Though they may work differently, the goal is the same: to calculate the estimated dividends a stock will pay out in future years.

One of the simplest ways to calculate the dividend discount model involves using dividend per share. This is simply the sum total of dividends paid out by a company per outstanding share of stock. This method allows you to find a stock’s value by dividing its dividend per share by the rate of return you require from the investment minus the expected dividend growth rate.

For example, say a company’s dividend per share is $2. Your target rate of return is 7% and you expect a dividend growth rate of 5% per year. In that case, the dividend discount model formula would look like this:

$2/(0.07 – 0.05) = $100

That $100 represents what the stock’s price should be, based on the current dividend per share, divided by the required rate of return minus the dividend growth rate.

You can also use the model to estimate your rate of return, based on current dividend payments and future dividend growth. To use DDM this way, you’d divide the dividend payment by the stock price, then add the dividend growth rate. The final number would be your expected rate of return from the investment.

So using the same numbers, you’d flip the formula around.

($2/$100) +.05 = 7%

Broadly speaking, these formulas can help you decide whether a stock’s value matches up to its share price and whether that share price is something you’re willing to pay to generate your target rate of return.

How to Use DDM to Invest

Black man checks his investmentsWhether you use stock value or rate of return as your endpoint when calculating the dividend discount model, you can use it to decide if a stock is a good fit for your investment portfolio, based on your investment goals. For example, say that you use the first method, which relies on dividend per share to assess values. When you run the calculations, the number you end up with for stock value is more than what the stock is currently trading at. In that scenario, the dividend discount model could indicate that a stock is undervalued. In that case, it could make sense to buy in if you anticipate that the share price will increase over time.

On the other hand, if you get a number that’s lower than what a stock is currently trading at, that could signal that it’s overvalued. You may want to wait until the stock’s price drops to buy shares. Or if you already own the stock, you may want to sell while prices are high if you expect them to fall.

The same is true for the rate of return method. If you run the numbers and arrive at a figure that’s close to your target rate of return then it could be worth investing in. On the other hand, if the expected rate of return is significantly below what you’re hoping for then you may want to consider another stock instead.

Dividend Discount Model Limitations

The dividend discount model can be used to estimate stock values but it isn’t a perfect measurement. For example, the DDM formula may not work as well when it’s applied to companies that don’t have a consistent rate of dividend growth or don’t pay out dividends regularly. It’s also difficult, though not impossible, to use this formula with newer companies that are just getting started with dividend payouts.

You can also run into problems when trying to use the dividend discount model to value companies that post a lower rate of return compared to the dividend growth rate. If this happens, it usually means that the company is reporting lower earnings or losing money, while still paying out dividends to investors. That could be a sign that the company is in trouble financially.

Generally, the dividend discount model works best when it’s used to evaluate larger, more established companies. For example, you may use to measure valuations for the Dividend Aristocrats or Dividend Kings, which include companies that have consistently increased their dividend payout for 25 and 50 years consecutively.

The Bottom Line

Stock price chart

The dividend discount model can be used to make assumptions about a company’s value, though it’s not necessarily 100% reliable. When estimated stock values, it can also be helpful to look at company fundamentals, such as price to earnings, earnings per share and other financial ratios. You may also use technical indicators to track a stock’s pricing momentum. Together, these metrics can help you to paint a more complete picture of a company’s financial health and what its stock is truly worth.

Tips for Investing

  • Consider talking to a financial advisor about where dividend stocks might fit into your portfolio and how to evaluate which ones you should be investing in. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s financial advisor matching tool makes it easy to connect with professional advisors in your local area. It takes just a few minutes to get your personalized advisor recommendations online. If you’re ready then get started now.
  • If your investments pay off, you may owe the capital gains tax. Figure out how much you’ll pay when you sell your shares with our capital gains tax calculator.

Photo credit: ©iStock.com/Morsa Images, ©iStock.com/PeopleImages, ©iStock.com/solarseven

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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