What is the Dividend Discount Model? Valuation via Yield

The Dividend Discount Model (DDM) values a company's stock by forecasting next year's dividend and discounting it by the required rate of return.

The Dividend Discount Model (DDM) is a quantitative method used for predicting the price of a company's stock based on the theory that its present price is worth the sum of all of its future dividend payments when discounted back to their present value. It is most effective for valuing mature companies with stable, predictable dividend histories, such as utilities or consumer staples like Coca-Cola.

The most common variation is the Gordon Growth Model (GGM), which assumes dividends grow at a constant rate forever: $P = \frac{D_1}{r - g}$. In this formula, $P$ is the current stock price, $D_1$ is the expected dividend next year, $r$ is the constant cost of equity capital, and $g$ is the constant growth rate in dividends. For the formula to work, $r$ must be greater than $g$.

The DDM is highly sensitive to the inputs for $r$ and $g$. In 2022, as the Federal Reserve raised interest rates, the 'required rate of return' ($r$) increased for many investors. According to the formula, even if the dividend growth ($g$) remained steady, the increase in the denominator $(r - g)$ led to a significant compression in stock valuations for dividend-paying equities. This model fails to value companies that do not pay dividends or those that prioritize share buybacks over cash distributions.