Learn about the Dividend Discount Model for common stock valuation, including the zero-growth, normal growth, super-normal growth, single-period, and multi-period valuation models. Perfect for students of Fundamentals of Corporate Finance in BITM, BBA, and BBS courses in Nepal.
Thank you for reading this post, don't forget to subscribe!Introduction to the Dividend Discount Model (DDM)
The Dividend Discount Model (DDM) is one of the most fundamental and widely used approaches to valuing common stocks. It is based on a simple yet powerful principle — the value of a stock equals the present value of all its expected future dividends.
In the world of corporate finance, understanding DDM is crucial because it connects a company’s dividend policy, growth prospects, and required rate of return into a unified valuation framework.
This concept is an essential topic under the Fundamentals of Corporate Finance for BITM, BBA, and BBS courses in Nepal, providing future managers and analysts with tools to make sound investment decisions.
Concept of Dividend Discount Model (DDM)
The Dividend Discount Model assumes that the intrinsic value of a stock can be calculated as the sum of all expected future dividends discounted back to their present value using the investor’s required rate of return (k).
Where:
- P₀ = Current price of the stock
- D₁, D₂, … Dₙ = Expected dividends in each period
- k = Required rate of return
1. Zero-Growth Dividend Model
The Zero-Growth Model assumes that dividends remain constant indefinitely — meaning the company does not grow. This is often applicable to mature firms with stable earnings and predictable cash flows.
Where:
- D = Constant dividend per share
- k = Required rate of return
2. Normal (Constant) Growth Dividend Model – Gordon Growth Model
The Normal Growth Model, also known as the Gordon Growth Model (GGM), assumes that dividends grow at a constant rate (g) forever. It is suitable for companies with a stable and predictable growth pattern.
3. Super-Normal Growth Model
The Super-Normal Growth Model applies when a company experiences high growth for a limited period, followed by stable (normal) growth thereafter. This is common for new or rapidly expanding firms.
The valuation process involves two stages:
- Calculate the present value of dividends during the super-growth period.
- Calculate the present value of dividends during the stable growth period, using the Gordon Growth formula from that point onward.
Example:
If a company grows at 15% for 3 years, then stabilizes at 5%, analysts must discount dividends for the high-growth period separately and add the terminal value.
4. Single-Period Valuation Model
The Single-Period Model assumes that an investor plans to hold the stock for one year only. The value of the stock equals the present value of the expected dividend (D₁) plus the expected selling price (P₁) at the end of one year.
5. Multi-Period Valuation Model
The Multi-Period Model extends the single-period concept to multiple years. It discounts all expected dividends and the final selling price (or terminal value) back to the present.
This model is more realistic for long-term investors who hold stocks for several years.
Advantages of Dividend Discount Model
- Simple and conceptually sound for dividend-paying firms.
- Focuses on long-term value rather than short-term market fluctuations.
- Provides clear linkage between dividends, growth, and required returns.
Limitations of Dividend Discount Model
- Not suitable for non-dividend-paying companies.
- Difficult to estimate future growth rates accurately.
- Sensitive to small changes in k and g values.
Conclusion
The Dividend Discount Model remains one of the most fundamental tools in corporate finance for valuing common stocks. Whether using the zero-growth, normal growth, or super-normal growth approach, DDM offers a structured way to determine a stock’s intrinsic value based on dividend expectations and required returns.
For students of BITM, BBA, and BBS courses in Nepal, mastering this model is essential for understanding investment decisions, stock pricing, and portfolio management.
FAQs on Dividend Discount Model for Common Stock Valuation
Q1. What is the main idea behind the Dividend Discount Model?
The main idea is that the value of a stock equals the present value of all future expected dividends.
Q2. When should I use the Zero-Growth Model?
It is used when a company pays a fixed dividend without any expected growth, usually in mature industries.
Q3. What is the difference between the Normal and Super-Normal Growth Models?
The Normal Growth Model assumes a constant growth rate forever, while the Super-Normal Growth Model assumes high growth for a limited time before stabilizing.
Q4. Is DDM applicable to companies that do not pay dividends?
No, DDM is effective only for companies that pay regular dividends. For others, models like the Free Cash Flow Model (FCF) are preferred.
Q5. How does growth rate affect stock valuation?
A higher growth rate increases the expected future dividends, thereby increasing the stock’s intrinsic value.