How does the dividend discount method (DDM) work?

Investors can use the dividend discount model (DDM) for stocks that have just been issued or that have traded on the secondary market for years. There are two circumstances when DDM is practically inapplicable: when the stock does not issue dividends, and when the stock has a very high growth rate.

The DDM is very similar to the discounted cash flow (DCF) valuation method; the difference is that DDM focuses on dividends. Just like the DCF method, future dividends are worth less because of the time value of money. Investors can use the DDM to price stocks based on the sum of future income flows by the risk-adjusted required rate of return.

Each common share represents an equity claim on the issuing corporation's future cash flows. Investors can reasonably assume that the present value of a common stock is the present value of expected future cash flows. This is the basic premise of DCF analysis.

The DDM assumes that dividends are the relevant cash flows. Dividends represent income received without loss of asset (selling the stock for capital gains) and are comparable to coupon payments from a bond.

Even though DDM advocates believe that, sooner or later, all firms will pay dividends on their common stock, the model is much more difficult to use without a benchmark dividend history.

The formula for using DDM is most prevalent when the issuing corporation has a track record of dividend payments. It's incredibly difficult to forecast when, and to what extent, a non-dividend paying firm will begin distributing dividends to shareholders.

Controlling shareholders have a much stronger sense of control over other forms of cash flow, so the DCF method might be more appropriate for them.

A stock that grows too quickly will end up distorting the basic Gordon-Growth DDM formula, possibly even creating a negative denominator and causing a stock's value to read negative. There are other DDM methods that help lessen this issue.