Dividend Discount Model

What is the DDM?

A procedure of valuing a stock price by taking its predicted dividends and discounting them back to the present value. If the stock is trading at a price less than the DDM price, then the stock is considered to be undervalued.

DDM Equation

Dividend per share / (r-g) * r = Discount rate. Typically Cost of Equity g= Dividend growth rate

A more in depth way to think about DDM

1. Project out the company's earnings, down to earnings per share (EPS). 2. Assume a dividend payout ratio - what percentage of the EPS actually gets paid out to shareholders in the form of dividends - based on what the firm has done historically and how much regulatory capital it needs. 3. Use this to calculate dividends over the next 5-10 years. 4. Do a check to make sure that the firm still meets its target Tier 1 Capital and other capital ratios - if not, reduce dividends. 5. Discount the dividend in each year to its present value based on Cost of Equity - NOT WACC - and then sum these up. 6. Calculate terminal value based on P / BV and Book Value in the final year, and then discount this to its present value based on Cost of Equity. 7. Sum the present value of the terminal value and the present values of the dividends to get the company's net present per-share value.