The dividend discount model (DDM) is a valuation method that estimates a stock's fair value as the present value of all the dividends it is expected to pay in the future, discounted at the investor's required rate of return. Its most common form, the Gordon growth model, assumes dividends grow at a constant rate forever, giving a simple closed-form formula for valuing dividend-paying shares.
Worked example
A stock is expected to pay a $2.00 dividend next year, growing at 4% per year indefinitely. The investor's required return is 9%. Using the Gordon growth model, value = D₁ ÷ (r − g) = $2.00 ÷ (0.09 − 0.04) = $2.00 ÷ 0.05 = $40.00 per share.
Why it matters
The DDM is intuitive for mature, steady dividend payers because it ties value directly to cash returned to shareholders. Its biggest pitfall is sensitivity: the value explodes as the growth rate approaches the discount rate, and the model breaks down entirely if growth is assumed to equal or exceed the required return. It is also unusable for companies that pay no dividends.
Frequently asked questions
No. The DDM relies on a stream of dividends, so it cannot value companies that pay none. For those, analysts use a free-cash-flow DCF or a relative-valuation approach instead.
Because value equals D₁ ÷ (r − g), the denominator shrinks fast as the growth rate g approaches the required return r. Small changes in either assumption can swing the estimated value dramatically.