It’s one of the basic applications of a financial theory that students in any introductory finance class must learn. Unfortunately, the theory is the easy part. The model requires loads of assumptions about companies’ dividend payments and growth patterns, as well as future interest rates. Difficulties spring up in the search for sensible numbers to fold into the equation.
The Dividend Discount Model
Here is the basic idea: any stock is ultimately worth no more than what it will provide investors in current and future dividends. Financial theory says that the value of a stock is worth all of the future cash flows expected to be generated by the firm, discounted by an appropriate risk-adjusted rate. According to the DDM, dividends are the cash flows that are returned to the shareholder. (We’re going to assume you understand the concepts of time value of money and discounting. You can learn more about these subjects here.) Continue reading “Digging The Dividend Discount Model”