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    what is the model called that determines the present value of a stock based on its next annual dividend, the dividend growth rate, and the applicable discount rate?

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    Dividend Discount Model – DDM Definition

    The dividend discount model (DDM) is a system for evaluating a stock by using predicted dividends and discounting them back to present value.

    FUNDAMENTAL ANALYSIS TOOLS

    Dividend Discount Model – DDM

    By JAMES CHEN Updated March 06, 2022

    Reviewed by GORDON SCOTT

    Fact checked by JIWON MA

    What Is the Dividend Discount Model?

    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-day price is worth the sum of all of its future dividend payments when discounted back to their present value. It attempts to calculate the fair value of a stock irrespective of the prevailing market conditions and takes into consideration the dividend payout factors and the market expected returns. If the value obtained from the DDM is higher than the current trading price of shares, then the stock is undervalued and qualifies for a buy, and vice versa.

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    Dividend Discount Model

    Understanding the DDM

    A company produces goods or offers services to earn profits. The cash flow earned from such business activities determines its profits, which gets reflected in the company’s stock prices. Companies also make dividend payments to stockholders, which usually originates from business profits. The DDM model is based on the theory that the value of a company is the present worth of the sum of all of its future dividend payments.

    Time Value of Money

    Imagine you gave $100 to your friend as an interest-free loan. After some time, you go to him to collect your loaned money. Your friend gives you two options:

    Take your $100 now

    Take your $100 after a year

    Most individuals will opt for the first choice. Taking the money now will allow you to deposit it in a bank. If the bank pays a nominal interest, say 5%, then after a year, your money will grow to $105. It will be better than the second option where you get $100 from your friend after a year. Mathematically,

    \begin{aligned}&\textbf{Future Value}\\&\qquad\mathbf{=}\textbf{Present Value }\mathbf{^*(1+}\textbf{interest rate}\mathbf{\%)}\\&\hspace{2.65in}(\textit{for one year})\end{aligned}

    ​ Future Value =Present Value ∗ (1+interest rate%) (for one year) ​

    The above example indicates the time value of money, which can be summarized as “Money’s value is dependent on time.” Looking at it another way, if you know the future value of an asset or a receivable, you can calculate its present worth by using the same interest rate model.

    Rearranging the equation,

    \begin{aligned}&\textbf{Present Value}=\frac{\textbf{Future Value}}{\mathbf{(1+\textbf{interest rate}\%)}}\end{aligned}

    ​ Present Value= (1+interest rate%) Future Value ​ ​

    In essence, given any two factors, the third one can be computed.

    The dividend discount model uses this principle. It takes the expected value of the cash flows a company will generate in the future and calculates its net present value (NPV) drawn from the concept of the time value of money (TVM).1 Essentially, the DDM is built on taking the sum of all future dividends expected to be paid by the company and calculating its present value using a net interest rate factor (also called discount rate).

    Expected Dividends

    Estimating the future dividends of a company can be a complex task. Analysts and investors may make certain assumptions, or try to identify trends based on past dividend payment history to estimate future dividends.

    One can assume that the company has a fixed growth rate of dividends until perpetuity, which refers to a constant stream of identical cash flows for an infinite amount of time with no end date.2 For example, if a company has paid a dividend of $1 per share this year and is expected to maintain a 5% growth rate for dividend payment, the next year’s dividend is expected to be $1.05.

    Alternatively, if one spot a certain trend—like a company making dividend payments of $2.00, $2.50, $3.00 and $3.50 over the last four years—then an assumption can be made about this year’s payment being $4.00. Such an expected dividend is mathematically represented by (D).

    Discounting Factor

    Shareholders who invest their money in stocks take a risk as their purchased stocks may decline in value. Against this risk, they expect a return/compensation. Similar to a landlord renting out his property for rent, the stock investors act as money lenders to the firm and expect a certain rate of return. A firm's cost of equity capital represents the compensation the market and investors demand in exchange for owning the asset and bearing the risk of ownership.3 This rate of return is represented by (r) and can be estimated using the Capital Asset Pricing Model (CAPM) or the Dividend Growth Model. However, this rate of return can be realized only when an investor sells his shares. The required rate of return can vary due to investor discretion.4

    Companies that pay dividends do so at a certain annual rate, which is represented by (g). The rate of return minus the dividend growth rate (r - g) represents the effective discounting factor for a company’s dividend. The dividend is paid out and realized by the shareholders. The dividend growth rate can be estimated by multiplying the return on equity (ROE) by the retention ratio (the latter being the opposite of the dividend payout ratio). Since the dividend is sourced from the earnings generated by the company, ideally it cannot exceed the earnings. The rate of return on the overall stock has to be above the rate of growth of dividends for future years, otherwise, the model may not sustain and lead to results with negative stock prices that are not possible in reality.5

    Source : www.investopedia.com

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    What is the model called that determines the present value of a stock based on its next

    annual dividend, the dividend growth rate, and the applicable discount rate?

    Answer zero growth dividend growth capital pricing

    earnings capitalization

    discounted dividend

    Click card to see definition 👆

    b. dividend growth

    Click again to see term 👆

    Which one of the following is computed by dividing next year's annual dividend by the

    current stock price?

    Answer yield to maturity

    total yield dividend yield capital gains yield growth rate

    Click card to see definition 👆

    c. dividend growth

    Click again to see term 👆

    1/33 Created by nolancallecod Finance

    Terms in this set (33)

    What is the model called that determines the present value of a stock based on its next

    annual dividend, the dividend growth rate, and the applicable discount rate?

    Answer zero growth dividend growth capital pricing

    earnings capitalization

    discounted dividend b. dividend growth

    Which one of the following is computed by dividing next year's annual dividend by the

    current stock price?

    Answer yield to maturity

    total yield dividend yield capital gains yield growth rate c. dividend growth

    Which one of following is the rate at which a stock's price is expected to appreciate?

    Answer current yield

    total return dividend yield capital gains yield coupon rate capital gains yield

    Which one of the following types of stock is defined by the fact that it receives no

    preferential treatment in respect to either dividends or bankruptcy proceedings?

    Answer dual class cumulative non-cumulative preferred common common

    A company has two open seats, Seat A and Seat B, on its board of directors. There are 6

    candidates vying for these 2 positions. There will be a single election to determine the winner of both

    open seats. As the owner of 100 shares of stock, you will receive one vote per share for each open

    seat. You decide to cast all 200 of your votes for a single candidate. What is this type of voting

    called? Answer democratic cumulative straight deferred proxy cumulative

    You want to be on the board of directors of Wisely Foods. Since you are the only

    shareholder that will vote for you, you will need to own more than half of the outstanding shares of

    stock if you are to be elected to the board. What is the type of voting called that requires this level of

    stock ownership to be successfully elected under these conditions?

    Answer democratic cumulative straight deferred proxy straight

    You cannot attend the shareholder's meeting for Alpha United so you authorize another

    shareholder to vote on your behalf. What is the granting of this authority called?

    Answer altering cumulative voting straight voting indenture agreement voting by proxy voting by proxy

    What are the distributions to shareholders by a corporation called?

    Answer retained earnings

    net income dividends capital payments diluted profits dividends

    Which one of the following is a type of equity security that has a fixed dividend and a

    priority status over other equity securities?

    Answer senior bond debenture warrant common stock preferred stock preferred stock

    Callander Enterprises stock is listed on NASDAQ. The firm is planning to issue some new

    equity shares for sale to the general public. This sale will occur in which one of the following

    markets? Answer private auction exchange floor secondary primary primary

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    Dividend Growth Rate

    The dividend growth rate (DGR) is the percentage growth rate of a company’s stock dividend achieved during a certain period of time. Frequently, the DGR is

    Dividend Growth Rate

    The percentage growth rate of a company’s dividend achieved during a certain period of time

    Home › Resources › Knowledge › Finance › Dividend Growth Rate

    What is the Dividend Growth Rate?

    The dividend growth rate (DGR) is the percentage growth rate of a company’s dividend achieved during a certain period of time. Frequently, the DGR is calculated on an annual basis. However, if necessary, it can also be calculated on a quarterly or monthly basis.

    The dividend growth rate is an important metric, particularly in determining a company’s long-term profitability. Since dividends are distributed from the company’s earnings, one can assess and analyze its ability to sustain its profitability by comparing the DGR over time.

    Dividend Growth Rate and a Security’s Pricing

    Also, the dividend growth rate can be used in a security’s pricing. It is an essential variable in the Dividend Discount Model (DDM).

    The dividend discount model is based on the idea that the company’s current stock price is equal to the net present value of the company’s future dividends. Mathematically, the dividend discount model is written using the following equation:

    Where:

    P0 – the current company’s stock priceD1 – the next year dividendsr – the company’s cost of equityg – the dividend growth rate

    How to Calculate the Dividend Growth Rate

    The simplest way to calculate the DGR is to find the growth rates for the distributed dividends.

    Let’s say that ABC Corp. paid its shareholders dividends of $1.20 in year one and $1.70 in year two. To determine the dividend’s growth rate from year one to year two, we will use the following formula:

    However, in some cases, such as in determining the dividend growth rate in the dividend discount model, we need to come up with the forward-looking growth rate.

    Prior to studying the approaches, let’s consider the following example. Below is ABC Corp.’s schedule of paid dividends with the calculated annual DGR:

    There are three main approaches to calculate the forward-looking growth rate:

    1. Use historical dividend growth rates.

    a. Using the historical DGR, we can calculate the arithmetic average of the rates:

    b. We can also use the company’s historical DGR to calculate the compound annual growth rate (CAGR):

    2. Observe the dividend growth rate prevalent in the industry in which the company operates.

    Imagine that the average DGR in the industry in which the ABC Corp. is operating is 4%. Then, we can use that rate for ABC Corp.

    3. Calculate the sustainable growth rate.

    The sustainable growth rate is the maximum growth rate that a company can sustain without external financing. The sustainable growth rate can be found using the following formula:

    If ABC Corp.’s ROE is 15% and its dividend payout ratio is 65%, then the company’s sustainable growth rate will be:

    More Resources

    Thank you for reading CFI’s guide to Dividend Growth Rate. To keep learning and advancing your career, the following CFI resources will be helpful:

    CAGR Calculator Capital Gains Yield Ex-Dividend Date

    Return on Total Capital

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