The dividend discount model (DDM) is a method used to calculate the present value of the expected flow of future dividends from a dividend paying stock. If you’re interested in an explanation of the math behind the DDM search Google for dividend discount model as there are plenty of those kind of articles out there. For this article, though, I’m going to concentrate on the practicalities behind this stock valuation model so you can figure out if it makes sense to use it in your dividend stock research.

The basic idea behind the dividend discount model is that the only true value in owning a stock lies in the amount and security of present and future dividend payments. Although owning a dividend paying stock may result in capital gains profits if the share price appreciates during the holding period, they’re not factored in because they’re too hypothetical for use in making present value calculations. The DDM operates on the assertion that only dividends are solid enough metrics for stock share price valuation.

So, if dividends are the only true measure of the value of owning a stock, how do we calculate the present value of those dividends? In other words, how do we use expected dividend payments (future value) to figure out what a fair price is for a corporation’s stock today (present value)?

Suppose you’re researching a stock that pays a $0.25 dividend every quarter. Also suppose that, as an income investor, you’ve determined that you need to generate 4% on your portfolio to provide for your current income without depleting your investment base. The dividend discount model says that the current value of this stock would be the annual dividend ($1 in our example) divided by the return you require from the stock (4%). So, the present value for a stock with these characteristics (what you would be willing to pay to buy this stock at market today) would be $1 / 0.04 or $25.

Unfortunately, this simplified version of the dividend discount model assumes that the dividend payment will remain constant for as long as you own the stock. In the real world, dividend payments can be cut or, ideally, grow over time so the basic version of the DDM only provides a present value for the stock based on the current dividend being paid by the corporation.

More comprehensive versions of the dividend discount model like the constant growth DDM (a.k.a. the Gordon Model) have been constructed that attempt to factor in both the expected growth of a dividend over time and the risk associated with certain types of dividend payments. This makes them more valuable as projection tools but takes them farther away from the original idea behind the DDM. After all, what difference is there between forecasting potential share price appreciation and forecasting potential dividend appreciation?

Although past performance can’t accurately predict future results, with dividend paying stocks you only really have the company’s history of faithfully paying dividends and growing those payments over time to judge how likely it is that they will continue doing so into the future. Speculating that they will continue to pay those dividends and grow them at historical levels is a logical assumption but it’s still an assumption.

Therefore, although the DDM is a valuable tool, it’s far from an unfailingly objective and accurate predictor of a dividend paying stock’s present value. At some point you have to factor in an opinion about the future security and growth of those dividend payments and that’s where the dividend discount model becomes more subjective – especially the farther into the future you try to predict.