Question

Can someone please paraphrase this?

Dividend Discount Model (DDM) - The DDM is based on the assumption that the company’s dividends represent the company’s cash flow to its shareholders. So valuing the present value of these cash flows should give the investor value for how much the shares should be worth. The model states that the intrinsic value of the company’s stock price equals the present value of the company’s future dividends.

The first step is to determine if the company pays a dividend.

The second step is to determine whether the dividend is stable and predictable since merely paying the dividend is not enough. The companies that pay stable and predictable dividends are typically mature blue-chip companies in well-developed industries. These types of companies are best suited for the DDM valuation model.

For example, take the following data of a company XYZ:-

Answer 1

Dividend Discount Model (or DDM) is used for valuation of securities of companies based on th eestimated dividend to be declared, the required rate of return and growth rate. The model tries to estimate the intrinsic value of shares of companies by using the requisite rate of return. Accoding to this model

Price of a share = Do(1+g)/(Ke-g)

where Do = Dividend declared by the company for the last year

g = Growth rate

Ke = Required rate of return.

The assumptions of the modle are

1. Dividend is declared at a stable rate

2. Growth rate of the company is constant.

3. Ke is given and constant.

One of the important assumption is constant growth rate, i.e growth rate will remain same during the coming years. However this may be true for typically mature blue-chip companies in well-developed industries, and therefore more useful for valuing these stocks. If the growth rate fluctuates this model cant be applied unless growth rate become constant.

For example

If Do = $ 2 g = 10%, Required rate of return = 15%,

then Price of share (Intrinsic value) = Do(1+g)/Ke - g = 2(1+0.10)/(0.15-0.10) = 2.2 / 0.05 = $ 44.