- Working process of DDM
- Types of Dividend Discount Model
- Advantages of DDM
- Disadvantages of DDM
Working process of DDM
The dividend discount model works on the principle of the value of cash. It’s engineered on the belief that the intrinsic price of a stock can show the current price of all the long-run income or the dividend attained from a stock. Dividends are invariably positive money flows that are distributed by a corporation to its shareholders. The dividend discount model in and of itself needs no complicated calculation and is user-friendly. It’s the best thanks to estimating the honest stock value with minimum mathematical inputs. It helps in determining whether or not a stock is undervalued or overvalued supported by the comparison between the amount derived from the model and also the current stock value prevailing within the market.
Types of Dividend Discount Model
Zero Growth DDM
This is the standard technique of the dividend discount model that assumes that the complete dividend paid throughout stock is going to be similar and constant forever till infinite. It considers that there’ll be no growth within the dividend and so the stock value is going to be capable of the annual dividend divided by the speed of returns.
Constant growth rate DDM
This model takes into the assumption that the dividends are growing solely at a set share or continuously annually. There’s no variability and also the share growth is the same throughout. This is often conjointly called the Gordon Growth Model and assumes that dividends are grown by a set specific share every year. Constant growth models are specific to the valuation of matured firms solely whose dividends are growing steadily over time.
Variable Growth DDM or Non-Constant Growth
The model takes into the belief that the expansion is going to be divided into 3 or four phases. The primary one is going to be a quick initial section, then a slower transition section, and at last ends with a lower rate for the finite amount. This is often additional realistic compared to the opposite 2 strategies. The model solves the matter of a corporation giving unsteady dividends that could be a true image throughout the variable growth phases of a corporation.
Further, the variable rate of growth model is more divided into many parts:
Two Stage of DDM
Model to work out the worth of equity of business with twin growth stage. There’s the initial amount of quicker growth than a sequent amount of stable growth.
Three Stage DDM
Model to work out the worth of equity of a business with 3 growth stages. The primary one is going to be a quick initial section, then a slower transition section, and at last ends with a lower rate for the finite amount.
Advantages of DDM
The advantages are as follows:
- Proven and Sound Logic: The most conception used here is that the value of money supported the long-run cash flows that are nothing but dividends. It’s little or no exposure to some mathematical models or assumptions that even additionally makes the model trustworthy.
- Consistency: Several firms pay their dividends within the sort of money and so the topic is incredibly on the point of the basics of a corporation. So the corporate can ne’er try and manipulate this range because it will hamper their stock value volatility which implies this model could be a trusty one.
- Matured Business: The payment of dividends that is going on often invariably doesn’t imply that the corporate has matured and there’s no volatility concerned. So this model comes helpful for investors preferring to speculate in an exceedingly stock that pays regular dividends.
Disadvantages of DDM
The disadvantages are as follows:
- Sensitive Assumptions: As we all know the honest value is incredibly sensitive to growth rates and also the rate of comeback needed. So 1 Chronicles increase or decrease in our assumption of each will affect the valuation of the stock.
- May Not Be Earnings Related: Dividends ought to correlate with earnings. On the contrary, firms try and have a set or constant dividend pay-out rather than variable pay with the earnings.
- Specific to mature firms only: The model is additional specific to mature firms solely and it’s restricted to high-growth firms.
The dividend rate of growth model could be an effective method of valuing matured firms. It’s advantageous as a result of its rather more reliable and tried. Since it doesn’t rely on mathematical assumptions and techniques it’s rather more realistic.