Features and Faults of the Dividend Discount Model

The dividend discount model is a method that investors use to attempt to value a stock based on the value of the dividends that it pays. This method has both some merit and some drawbacks. The basic idea behind the dividend discount model is that you can determine the value of a stock by looking at the dividends that it pays. If someone is getting a certain amount of money from the dividends, investors would be willing to pay a specific amount. This tells you how much you should be willing to pay for the stock and whether the price for it is currently undervalued, or overvalued. As with all valuation formulas, there are some inherent problems with the model. However, you can potentially get some useful information out of using this model.

Basic Formula

The basic formula for the dividend discount model is very simple. You will take the price of the dividend that was paid and divide that by an expected rate of return. For example, let's say that you had a company that paid a \$10 dividend. Let's also say that you had an expected rate of return of 5 percent. In this case you would take the price of \$10 and divide it by .05. This gives you a number of \$200. This would mean that the value of the stock should be \$200 per share at that particular time.