Dividend Discount Model (DDM)
Candlefocus EditorThe DDM model is based on the time value of money concept which states that a single dollar today is worth more than that same dollar tomorrow, as it can be invested and used to earn interest. Therefore, in the DDM, present value is calculated by first discounting future cash flows at the required return rate of the investor, or the “discount rate”. This discount rate takes into account the time value of money, the risk associated with the security and the company’s current dividend yield. Once an estimate of the stream of future cash flows have been discounted, the present value of those cash flows is then subtracted from the current market price of the stock to determine whether it is currently undervalued or overvalued.
The DDM is especially useful for long-term investors as it allows them to estimate the stock’s fair market value by making assumptions about the company’s future performance and discounting those cash flows back to present value. Additionally, the DDM can be used to compare different companies, as the value of their stock can be estimated by examining their dividend history and their expected future dividends.
By taking into account the time value of money, the DDM is a powerful tool for investors to use in their decision-making process. By properly estimating a stock’s fair market value, investors can more accurately judge which stocks to buy and sell. The DDM is commonly used by investors to estimate the intrinsic value of a company’s stock and make a “buy” or “sell” decision.