Dividend Discount Model (DDM) Cheatsheet

The 10-second version

The DDM values equity as the present value of all future dividends. In its simplest Gordon Growth form for a mature, stable dividend payer: P₀ = D₁ / (k − g), where D₁ is next year’s dividend, k is cost of equity, and g is perpetual growth (k > g required).

Core idea in one line

Value today equals discounted, growing dividends—if growth is stable and less than your required return.

DDM building blocks

• D₁ (next dividend): D₁ = D₀ × (1 + g).
• k (cost of equity): Required return for shareholders (often estimated via CAPM or by judgment).
• g (long-run dividend growth): Should reflect sustainable growth, not short bursts.

Sustainable growth often tied to g = retention ratio × ROE (a.k.a. internal growth).

Gordon Growth Model (stable stage)

For firms with steady payout policies and mature economics:

P₀ = D₁ / (k − g),   with  k > g

Dividend yield + growth heuristic: If you prefer intuition, expected return ≈ D₁/P₀ + g (ignoring valuation changes). Rearranged, P₀ ≈ D₁ / (k − g).

Multi-stage DDM (when growth changes)

1. Forecast dividends for a high-growth period (years 1…N).
2. Discount them at k to present.
3. Apply a terminal Gordon stage from year N+1 using a stable g*:
   PN = DN+1 / (k − g*).
4. Present value of PN plus the PV of explicit dividends = P₀.

Useful for firms transitioning from high growth to maturity (banks, consumer staples, utilities, etc.).

Choosing inputs that won’t fool you

• Dividend policy: Use expected payout, not just last year’s spike/cut.
• Cost of equity (k): Cross-check CAPM with history/peers and country risk; use a range.
• Sustainable g: Keep g ≤ long-term nominal GDP growth of core market; link to retention × ROE.
• Buybacks vs dividends: Classic DDM uses cash dividends; if buybacks dominate, consider a total payout model.

Worked example (toy numbers)

Company pays D₀ = ₹12 per share. You estimate g = 4% long run, and k = 10%. Then D₁ = 12 × 1.04 = ₹12.48.

Price: P₀ = 12.48 / (0.10 − 0.04) = 12.48 / 0.06 = ₹208.00.

Sensitivity matters: if k rises to 11% (same g), P₀ drops to ₹178.3; if g falls to 3%, P₀ is ₹178.3 as well.

Sustainable growth: the quick diagnostic

• Retention (b): 1 − payout ratio.
• ROE (quality): Higher, stable ROE supports higher g.
• g ≈ b × ROE: If payout is 60% and ROE is 15%, then g ≈ 0.40 × 0.15 = 6% (check if realistic vs economy).
• Coverage checks: Dividend/FCF coverage > 1 over cycle? Rising debt to fund payouts is a red flag.

Variants you’ll meet

• Two-stage DDM: High growth for N years → stable Gordon stage.
• H-model: Growth decays linearly from ghigh to gstable over horizon 2H.
• Total payout model: Replace dividends with (dividends + buybacks) for firms that prefer repurchases.
• No-dividend firms: Classic DDM isn’t appropriate—use FCFE/FCFF or a multiples approach.

Pros & cons

Common pitfalls

• Setting g ≥ k: Breaks math and economics.
• Using windfall dividends: Normalize to a policy level.
• Ignoring capital needs: Payouts funded by debt/asset sales aren’t sustainable.
• Currency mismatch: Match k, g, and dividends in the same currency/inflation regime.
• Mixing buybacks without adjusting: Consider total payout if repurchases are material and persistent.

Five-minute checklist

• Is the firm a consistent dividend payer with a clear policy?
• Are k and g estimated in the same currency/inflation and with a range?
• Does g pass the sustainable growth sniff test (retention × ROE, ≤ nominal GDP)?
• Have I checked coverage (FCF, earnings) and leverage trend?
• Have I run a sensitivity table over k and g, and a scenario with total payout?

Bottom line

Use the Gordon DDM when dividends are reliable and growth is steady: P₀ = D₁ / (k − g) with k > g. For transitions, use multi-stage models. Keep inputs realistic, test sensitivities, and consider total payout where buybacks dominate.