Dividend discount models are valuation models that are utilized to identify stocks that are currently undervalued. This mathematical approach makes it possible to identify the price per unit that the stock should be selling at. The dividend discount model takes into consideration the projection of dividend payments that will take place in the future and how they relate to the current discounted value of the stock issue.
The basic formula for a dividend discount model requires that the current market value of the corporation’s equity be a known factor. Ideally, the current market value will be the same as the present value of anticipated dividend payments that are set for issue over the next several periods. However, this formula makes a couple of assumptions that may or may not come to pass.
A dividend discount model is a valuation model that relies on one of two assumptions. In one common scenario, the assumption is that the dividend payments are fixed and are not likely to change in the near future. The second scenario calls for recognizing that the dividend payments may grow as a small but constant rate. With this second approach, the equity of the company is considered to be a perpetuity. Understanding which scenario is applicable to the stock under consideration is very important, as it will impact how the dividend payment relates to the company’s equity.
There are variations off these two basic approaches to a dividend discount model. Often, these variations are ways to account for factors that are unique to the company in question, and how those factors impact the equity of the company. Because the model can be calculated using various data above and beyond the basic models, not all financial analysts consider this approach to be especially helpful.
Not every company can make use of a dividend discount model. One obvious exception is companies that do not issue dividends. However, even companies that do issue dividends may find the formula has only limited value at best when it comes to evaluating the overall equity of the company and how it relates to the structure in place for issuing dividends to shareholders.