Dividend Discount Model (DDM)

The logic is that, for a shareholder who holds on to a share indefinitely, the only cash they ever receive from the company is dividends. So the share's value today should equal those future dividends discounted back to the present at the shareholder's required rate of return.

In practice, analysts make simplifying assumptions about how dividends will grow. The simplest version, the Gordon Growth Model, assumes dividends grow at a constant rate forever. Multi-stage versions assume faster growth for a few years before settling into a lower, steady rate.

For example, a company expected to pay a dividend of 2 next year, growing at 3% a year, with a required return of 8%, would be valued at 2 divided by 5%, which is 40 per share, using the constant-growth version.

The DDM works best for mature, stable companies that pay regular, predictable dividends, such as utilities and some banks. It is less useful for companies that pay small or no dividends, such as many fast-growing technology companies, or whose dividends are irregular.