Discounted Dividend Model (DDM): What It Is & How to Use It

Accurately valuing a company is essential when managing its finances. To achieve this, you must conduct a valuation.

Valuation is the process of translating financial forecasts into an estimate of a company's worth.

“Valuation is inherently an estimate,” says Harvard Business School Professor Suraj Srinivasan, who teaches the online course Strategic Financial Analysis. “Your results can be different from the estimates of others, and the estimate of value can change as the context and circumstances change.”

While specific methods vary, all aim to determine the present value of future gains from an asset, such as dividends. One common approach is the discounted dividend model (DDM).

What Is the Discounted Dividend Model (DDM)?

The discounted dividend model (DDM) is a formula for determining a company’s equity value by calculating the present value (PV) of projected future dividends.

To break that down:

• Dividend: A distribution of earnings to shareholders, usually in the form of a stock reinvestment or cash return, often paid at regular intervals on a yearly or quarterly basis
• Equity value: The total value of a company’s shares, representing shareholder ownership
• Present value: The current worth of a future financial return, based on the time value of money—a core financial principle that states a sum of money available now is worth more today than it will be in the future

DDM operates on the principle that a company’s current value is the sum of all its estimated future dividends, discounted to their present worth. This model is a specific form of discounted cash flow analysis, which considers dividends as the primary cash flow component.

How Does the Discounted Dividend Model Work?

DDM is used to determine the value of shareholders’ investment in a company over a set period. It helps assess a company’s current value or compare it to competitors within its industry. The DDM equation, as taught in Strategic Financial Analysis, is:

Equity Value = Present Value of Expected Future Dividends

V₀ = div₁ / (1 + r_e)¹ + div₂ / (1 + r_e)² + div₃ / (1 + r_e)³ + ...

= ∑ from t = 1 to ∞ ( div_t / (1 + r_e)^t )

Here’s a breakdown of the equation’s components:

• V₀ = The company’s equity value, or the value of all its shares
• divₜ = The expected future dividend for a specific period, typically a year or quarter
• r_e = The required rate of return for that period
• t = The number of years you're estimating for, usually five to 10

The core of the DDM equation is based on the equation for the time value of money:

Expected Future Dividend (divₜ ) = Present Dividend Value x (1 + r_e)ᵗ

Present value accounts for the theory that $1 today is worth more than $1 in the future due to factors like inflation and opportunity cost. This equation models that same idea.

By rearranging the variables, you’ll get:

PV = divₜ / (1 + r_e )ᵗ

In this equation, the future dividend is discounted to reflect its present value (PV), which is how the formula earns its name.

Equity value is the sum of these discounted future dividends. The full DDM equation applies this calculation to each period—year over year or quarter over quarter—and then adds the results together.

An Example of the Discounted Dividend Model

Let’s say a hypothetical company, XYZ Corp, expects dividends to grow over the next three years from $20 million to $30 million to $50 million. For simplicity, assume the rate of return is a constant eight percent.

First, calculate the present value of each dividend for the respective years:

Adding these present values gives XYZ Corp’s equity value:

18.52 + 25.72 + 39.69 = 83.97 ≅ $84 million

Now that you've assessed XYZ Corp’s equity value at approximately $84 million, you can better evaluate its financial health and make informed decisions to grow its value.

DDM Considerations and Limitations

Keep in mind that the DDM equation is best used for companies that consistently pay dividends—typically mature, more established firms. Startups often reinvest their earnings into growth initiatives to drive future performance and long-term shareholder value.

Although the example assumes a constant rate of return, DDM can be adapted to account for changing interest rates, economic conditions, and debt financing.

DDM is often applied over a finite time frame; however, variations like the Gordon Growth Model can extend its use indefinitely. These models incorporate a terminal value, which assumes an established and reliable company's dividends will grow at a constant rate indefinitely. While this can be useful for theoretical modeling, it can also become increasingly inaccurate—and irresponsible—the farther into the future your estimate goes.

“We’re increasingly seeing a vigorous debate on what it means to create and capture value for a given company’s shareholders if, in the process, the company is destroying value for society,” Srinivasan says in Strategic Financial Analysis. “For instance, can you consider that a company is creating value if they create negative externalities for society by causing environmental harm while maximizing stock price for shareholders?”

While some may argue otherwise, infinite growth within a finite system remains an economic challenge. Similarly, the DDM becomes less accurate over longer periods.

Determining Value Through DDM

By understanding the time value of money, you can see how your company’s equity growth potential influences its present valuation. Using the discounted dividend model (DDM), you can estimate your business's present and future states.

To learn more about DDM, valuation, and ratio analysis, explore the online finance course Strategic Financial Analysis. Through interactive exercises and real-world business examples, you’ll gain the skills to apply these concepts confidently and advance your career.

Do you want to learn essential financial concepts and improve your business’s performance? Explore Strategic Financial Analysis—one of our online finance and accounting courses. To get a jumpstart, download our free Financial Terms Cheat Sheet to start improving your financial fluency.