Series 65: 2.16.3.1.1 Dividend Discount Model

2.16.3.1.1  Dividend Discount Model

The term dividend discount model (DDM) is used to refer both to a theory about assessing a stock’s fair value based on its dividends, and also to a commonly used ratio based on that theory. According to the theory, an estimate of the future growth rate of the dividends can be used to estimate what the share price “should” be for that stock. For obvious reasons, the model only works with stocks that pay dividends. The formula for the estimate is:

The expected rate of return is the annual return an investor wants or needs to receive for the investment to be worthwhile. You can set the expected rate of return to any value you want, within reason. When talking about the DDM specifically, the expected rate of return refers to the overall return from the investor’s entire portfolio, not necessarily from that one stock. In other contexts, the term may refer to returns from a single investment.Given a certain expected rate of return, the DDM formula will tell you the maximum price you “should” be willing to pay in order to m