Dividend Discount Model
A dividend discount model is a financial model for valuing the price of a stock by using predicted dividends and discounting them back to present value. The idea is that if the value obtained from the DDM is higher than what the shares are currently trading at, then the stock is undervalued.
This model would typically be a discounted cash flow (DCF) using dividend forecasts over several stages. And how this model works is as follows :
1. The expected dividends are estimated for the high growth period, using the payout ratio for the high growth period and the expected growth rate in earnings per share.
2. The expected growth rate is estimated either using fundamentals: Expected growth = Retention Ratio * Return on Equity. Alternatively, you can input the expected growth rate. At the end of the high growth phase, the expected terminal price is estimated using dividends per share one year after the high growth period, using the growth rate in stable growth, the payout ratio in stable growth and the cost of equity in stable growth.
3. The dividends per share and the terminal price are discounted back to the present at the cost of equity changes. If your cost of equity in stable growth is different from your cost of equity in high growth, the cost of equity in the second half of the stable growth period will be adjusted gradually from the high growth cost of equity to a stable growth cost of equity.
