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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.

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## 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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## 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

## 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

## Chapter 8

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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

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

current stock price?

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?

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?

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?

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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Source : corporatefinanceinstitute.com

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James 9 month ago

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