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Rev. Jul. 22, 2014

THE DIVIDEND DISCOUNT MODEL

Practitioners rely on a number of different approaches to estimate the value of corporate

assets. Value can be estimated using accounting, liquidation, or replacement cost data; from
multiples based on comparable companies or transactions; or by discounting a stream of
expected future benefits back to the present. The discounted cash flow (DCF) approach considers
stock price to be the present value of future cash flows. This note focuses on the DCF approach
and, in particular, the dividend discount model (DDM) or Gordon growth model (so-called
because it was devised by Professor Myron Gordon in 1962). The DDM is based on the premise
that the future cash flows an investor receives from a stock are cash dividends. In practice, the
DDM appears in many forms. In this note, we focus on its role in estimating the intrinsic value of
an equity security and as a model for estimating the required return on equity. After those
concepts are established, we explore the DDM’s link to price-earnings ratios, a widely followed
market multiple, and to the sustainable rate of growth.

Intrinsic Value

The DDM assumes that value is a direct function of the cash flows expected in the future.
In the case of a common stock, the relevant cash flows are the dividends paid plus the value of
the stock when sold. The price or value of a share derived from the future stream of dividends is
often referred to as the intrinsic value of the stock. Assuming that dividends are paid at the end
of each year and using subscripts to denote the year of receipt, we can depict, with the following
time lines and formulas, how investors can estimate a fair price for a stock they expect to hold
for three years:
D1 D2 D3 + P3

P0

This note was prepared by Susan Chaplinsky and Robert S. Harris and draws on earlier material developed by Ken
Eades in UVA-F-0909. Copyright  1998 by the University of Virginia Darden School Foundation, Charlottesville,
VA. All rights reserved. To order copies, send an e-mail to sales@dardenbusinesspublishing.com. No part of this
publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by
any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden
School Foundation.

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D1 D2 +
P0 = 1
+ 2
+ D3 P 3 3 (1)
(1 + K E ) (1 + K E ) (1 + K E )

In words, Equation 1 says that the price paid today (P0) equals the present value of the dividends
to be received each year plus the expected value of the stock at the end of the third year. The
required return (KE) is simply the discount rate that shareholders in the market are applying to
the stock. The subscript E refers to the fact that stocks are also called equities.

The person who buys the stock in year three faces a similar set of cash flows over the
next three years:
D4 D5 D6 + P6

P3

D4 D5 + P6
P3 = + + D6 (2)
(1 + K E ) (1 + K E ) (1 + K E )3
1 2

Substituting Equation 2 into Equation 1 for P3, we get:

D1 D2 D3 D4 D5 +
P0 = 1
+ 2
+ 3
+ 4
+ 5
+ D 6 P 66 (3)
(1 + K E ) (1 + K E ) (1 + K E ) (1 + K E ) (1 + K E ) (1 + K E )

Equation 3 illustrates that the original investor must predict not only the dividends received
while holding the stock, but also the dividends to be received by the next investor. Of course, if
we were to substitute for P6, the string of discounted dividends would be even longer, and the
present value of the ending price would become a smaller portion of P0.

The problem appears at this point to have become unmanageable, because we have to
predict a seemingly endless series of future dividends. To circumvent that unwieldy task, we
must assume something about the relationship between the future and the current dividends. If
we can assume that dividends grow at a constant rate, then Equation 3 becomes simple. Let g
denote the constant growth rate such that

2
D1 = D0  (1 + g) and D2 = D0  (1 + g ) , and so on .

More generally, this is

Di = D0 (1 + g)i for period i = 1, 2,… (4)

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Substituting into Equation 3, we get

1 2 3 n
D0  (1 + g ) D0  (1 + g) D0  (1 + g)  (1 + g)
P0 = 1
+ 2
+ 3
+ . . . + D0 n
+ ...
(1 + K E ) (1 + K E ) (1 + K E ) (1 + K E )

If we assume that growth can continue indefinitely, we can take this expression to its
logical limit. It turns out the series converges to

D1
P0 = (5)
KE - g

Equation 5 is a form of the constant growth model that is quite manageable, provided we can
make reasonable estimates of g, the long-term growth rate of dividends.1 But what if the dividend
is zero or very low? What if the dividends have grown very quickly over the past few years? The
answer to those questions is that the model does not work either for fast-growing firms or for
firms that pay no dividends. The key word here is constant growth. This model, like any other,
works only insofar as it fits the situation to which it is applied.

The model works reasonably well for stable companies that are past the high-growth
phase of their development. For those types of companies, one can

 Estimate the historical growth rate of dividends per share (DPS)

 Use analysts’ projections of dividend growth (i.e., financial analysts who work for
brokerage firms or for an on-line service such as Value Line).

A major problem with using past data is that they may not extrapolate well into the
future. On the other hand, analysts’ forecasts may prove unreliable: after all, the analysts
themselves must forecast an uncertain future.

The following 10 years of data for Triangle Microsystems, Inc. (TMI), can be used to
estimate an historical growth rate.

Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
DPS 0.505 0.505 0.75 0.75 0.75 0.75 0.90 0.90 0.90 0.93

1
Technically speaking, Equation 5 holds up only when KE exceeds g. If g exceeds KE forever, the present value
P0 becomes infinitely large. In financial markets, we do not find stocks with infinite prices, which means that in
practice g does not exceed KE. The actual derivation of Equation 5 relies on taking the limit of the sum of a series of
numbers each of which is a multiple of the prior term.

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The growth rate of DPS during 1988 to 1997 can be computed by solving for the growth rate that
over nine periods would increase the initial dividend of $0.505 to its final value of $0.93. That is,

Future DPS = Present DPS × (1 + Annual growth rate)9

0.93 = 0.505  (1 + g)9
0.93 = 0.505  (1.07)9

Note that this is analogous to finding the interest rate that would convert a present value of
$0.505 to a future value of $0.93. The growth rate is 7%.

Suppose we are asked to determine the value of shares in TMI at the end of 1997. TMI is
expected to pay a dividend of $1 per share at year-end 1998, and based on our analysis of
historic data, we assume that the future constant growth rate in dividends will be 7% per annum.
Assume the market’s required return for TMI is 15%. Using the constant growth version of the
DDM in Equation 5, the price or intrinsic value of a share can be calculated as

P0 = $1.00/(0.15 − 0.07) = $1.00/0.08 = $12.50 per share.

Notice that D1, our estimate of next year’s dividend, is obtained by multiplying the current $0.93
dividend by 1 plus the growth rate (7%). Of course, if we had better information regarding next
year’s dividend, we would use that in lieu of this simple projection. In any event, the DDM
results in an estimate of the value of TMI’s equity today.

Finding the Required Return on Equity

The DDM can also be used to estimate the market’s required rate of return in order to
remain consistent with the observed market price and our assumptions about growth. This
estimated rate is also referred to as the market capitalization rate. To estimate this capitalization
rate we can rearrange Equation 5 as follows:

D1 + g
KE = (6)
P0

Equation 6 shows that the capitalization rate KE is the sum of next year’s dividend yield and the
expected growth in dividends. The dividend yield (D1/P0) measures the current cash income from
owning the stock. The growth rate g fuels expectations of a rising share price in the future.

We can extract an estimate of KE from Equation 6 because the stock price we observe in
the market is the outcome of a complex weighing of the benefits and risks investors foresee.
Given a value for the stock and estimates of the future dividends and growth, we can solve for an
estimate of the required return on the stock.2 This is conceptually similar to finding the yield to
2
A challenging aspect of finance is the number of different terms used to describe the same phenomenon. In the
above discussion, the terms opportunity cost, capitalization rate, and required return are equivalent in meaning.

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maturity from the price of a firm’s bonds—except for the fact that uncertainty about future cash
flows is much greater in the case of equity.

If the current stock price P0 is $12.50, then substituting into Equation 6 gives

$0.93(1.07)
KE = + 0.07
$12.50

= 15.0%

In interpreting Equation 6, we must keep in mind that it is the stock price P0 that adjusts in
financial markets so that the relationship shown in the equation will hold. If little growth is
expected in dividends (i.e., if g is low), share price (P0) will be relatively low, and hence
dividend yield (D1/P0) will be high. The result will be that the shareholder’s required return will
be satisfied largely by dividend yield. In contrast, if dividend growth is expected to be high, the
share price will be higher (all else being constant), and, as a result, the dividend yield will be
lower. In the higher-growth case, the shareholder’s required return may be satisfied largely by
the expected growth even if the current dividend yield is low.

Again, given reasonable assumptions about the stability of dividend growth rates,
Equation 6 can yield estimates of the return that shareholders demand from investing in a firm’s
stock. Due to the importance and difficulty of estimating KE, however, few analysts rely solely
on the DDM to make their calculations. Remember that the DDM is most appropriate for mature,
stable-growth companies. Many analysts prefer the risk premium model (adding premiums to
market interest rates) as a method for estimating KE.

The Link between the Dividend Discount Model and Price Earnings Ratio

One useful insight from the DDM appears in its link to the price to earnings (P/E) ratio.
As shown earlier in Equation 5, the standard formulation of the constant growth DDM is

D1
P0 =
KE - g

To see the link to the P/E ratio we need to take two steps. First, we can express dividends as the
product of earnings (E1) and a dividend payout ratio (δ = D1/E1). Hence, D1 = δE1. For example,
if a firm expects $5 (E1) per share in earnings and has a dividend payout ratio of 40% (δ = 0.4),
dividends equal $2 per share ($2 = 0.4 × $5.00). Second, in certain circumstances the growth rate
in dividends will be the same as the growth rate in earnings. Namely, as long as the return on
equity (ROE) and the dividend payout ratio are constant, and no outside funding is assumed,
dividends and earnings will grow at the same rate. To rewrite the DDM in terms of the P/E ratio,

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we simply substitute the percentage dividend payout ratio (δ) times earnings (E1 ) for D1 in
Equation 5.

 E1
P0 =
KE - g

Thus, after rearranging terms, the theoretical P/E ratio is


P/E = (7)
KE - g

Equation 7 shows that the P/E ratio increases with a firm’s growth prospects (g). Investors will
pay a higher P/E if they expect higher earnings in future years due to growth. The equation also
shows that P/E decreases the higher the risk of the company, since higher risks lead to higher
required returns (KE). The combination of lower P/E with higher risk is another manifestation of
the fact that investors dislike risk.

Further insight into the factors shaping P/E ratios can be gained by decomposing the
theoretical P/E ratio into an expression, often referred to as the Miller-Modigliani formula, after
its originators:3

1  PB  ( ROE  K E 
P/E =  1  
KE  KE  g 
(8)
P
P/E = Base  Growth Opportunities
E

where PB is the percentage plowback or earnings reinvested in the firm and ROE is the
percentage return earned on reinvested dollars. Because Equation 8 is derived under the
assumptions of a constant ROE and no outside funds, all investment by the firm is self-funded by
retained earnings. Following our previous example, if a firm expects $5 per share in earnings and
pays a $2 dividend per share, then $3 per share is reinvested in the firm. The percentage
plowback is thus 60%. Note that the percentage plowback is equal to 1 minus the dividend
payout ratio. In this case, PB is 60%, which is equal to 1 minus the 40% dividend payout ratio.

Intuitively, the base P/E is the value an investor would pay to receive a dollar indefinitely
in an investment with the risk of KE. One can conceive of the base P/E as the equivalent of a
perpetual bond, which pays a nongrowing dollar stream to investors. This flow is generated by
existing assets, sometimes referred to as assets in place, and requires no new net investment by

3
See Merton H. Miller and Franco Modigliani, Dividend Policy, Growth and the Valuation of Shares, Journal
of Business, October 1961.

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the firm.4 Consequently, the base P/E ratio is the proportion of the P/E ratio that is attributable to
the maintenance of steady-state operations and not to reinvestment opportunities.

Growth opportunities enter in two ways. The first is a necessary condition: the plowback
percentage must be positive. A firm cannot grow without continuing to invest in productive
activities. However, this alone is not sufficient to ensure value-creating growth. In addition, the
return on the dollars reinvested must exceed investors’ opportunity costs (ROE > KE), if value is
to be created and rewarded with a higher P/E.

Suppose a company’s stock sells for $66.67 per share and its forecasted earnings per
share (EPS) for the next period is $5. The firm’s expected ROE is 20%, the dividend payout ratio
is 40%, and the cost of equity is 15%. We assume that the future growth rate in dividends is
12%. Using Equation 7,

Theoretical P/E = [40% × (0.15 − 0.12)] = 13.33

which is the same as taking the ratio of price and earnings ($66.67/$5).

The 13.33 P/E can be decomposed into the value from no-growth investment
opportunities and the growth inherent in the firm’s reinvestment opportunities. The base P/E =
1/0.15 = 6.67; this reflects a no-growth scenario. Hence, the difference between the theoretical
P/E of 13.33 and the base P/E of 6.67 derives from the firm’s ability to produce superior returns
on the funds reinvested in the firm (ROE) relative to capital market returns (i.e., ROE > KE).
Investors generally have many opportunities for earning capital market returns, and they tend to
favor the stocks of firms that are able to consistently produce returns superior to the others.
Therefore, they bid the price of those stocks up, and as a consequence their price becomes high
in relation to current earnings. These stocks have high P/E ratios as a result.

From this relationship, we can summarize several key points about P/E ratios:

 If ROE = KE, the theoretical P/E is equal to the base P/E regardless of the level of
reinvestment or plowback. For example, a firm may have a high ROE but may lack
opportunities for investing at rates above investors’ required returns. These firms would
be priced to reflect the base P/E and would be perceived more like no-growth bonds. In
essence, if ROE = KE reinvestment creates no value.
 All else being equal, riskier stocks, those with higher KE, will have lower P/E ratios. The
lesser the bond-equivalent portion of a stock’s return, the greater the risk faced by
investors.
 All else being equal, the higher ROE is above KE, the more valuable are the growth
opportunities. The gap between the theoretical P/E and the base P/E increases with more
and more profitable reinvestment opportunities.

4
Typically the assumption is that new capital expenditures just equal the amount by which the assets depreciate,
leaving the firm’s net assets unchanged.

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 If ROE > KE, the theoretical P/E will be higher in relation to the base P/E the more the
firm plows back. Some firms may have only a few investments where the expected ROE
exceeds KE, whereas others may have an abundance of such opportunities. The scope and
extent of reinvestment opportunities will influence investors’ perceptions of the stock.
 Although we have written the expression as a perpetuity, it is unlikely given the forces of
competition that firms can sustain superior performance indefinitely. Thus, P/E ratios
have imbedded within them a forecast for how long a firm can sustain its competitive
advantage. By competitive advantage, we mean the time over which ROE will be able to
exceed KE.

This simple model yields a number of important insights about how the firm’s reinvestment
policies and opportunities create value for shareholders.

Special Case of DDM: Earnings Capitalization Model

Armed with a greater awareness of the factors embedded in the DDM, let’s return to the
issue of the cost of equity, and consider a special case of the dividend growth model called the
earnings capitalization model. The earnings capitalization model, or earnings yield, is also
sometimes used to estimate the cost of capital.

E1 , which implies that

P0 =
KE

E1
KE = (9)
P0

If we compare Equation 9 to Equation 8, we see that the earnings capitalization model is

equivalent to assuming in Equation 8 that ROE = KE. This, in turn, implies that P/E = 1/KE or
that KE = E1/P0. Consequently, this model assumes that the dollars currently being reinvested in a
firm earn exactly a fair rate of return, nothing more and nothing less. Such a situation is unlikely
for most firms, particularly for high-growth firms, which are by definition earning higher-than-
normal returns on their investments. The only real advantage to the earnings capitalization
approach is its simplicity. Of course, we recognize now that the right-hand side of Equation 9 is
the inverse of the P/E ratio discussed above and reported every day in the Wall Street Journal.
What could be easier or more convenient?

Unfortunately, there are many reasons to question the accuracy of the earnings
capitalization method. In particular it is often unreasonable to assume ROE = KE. For a growth
firm, we would expect the current earnings to be much lower than what is expected in the future.
On the other hand, P0 is likely to be relatively high because of the high expected future earnings
growth if reinvestment returns are above the required return. The result is that E/P for growth
firms is typically very low. If we use the earnings capitalization model inappropriately, a low E/P

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implies a low KE. In fact, growth companies frequently have P/E ratios that imply KE values
lower than Treasury bills! This tells us that the earnings capitalization model is not appropriate
for such high growth firms. The other extreme also occurs, because EPS may happen to be
abnormally high, making E/P much higher than the true cost of equity. The point is that the
applicability of Equation 9 is limited, and as a special case of the dividend growth model, it
must be used cautiously.

Both the dividend growth model and the earnings capitalization model require an analyst
to separate the effects of growth and risk. As we have discussed, this is an inherently difficult
task. Fortunately, there are other approaches to the cost of equity—the risk premium methods—
that allow for the separation of those factors. The risk premium models attempt to formulate risk-
adjusted rates by adding an appropriate premium for market risk to a base riskless rate. These
models rely on market parameters to measure risk that are unaffected by any individual firm’s
growth or dividends. As such, they provide an arm’s length estimate of an investors’ required
returns.

The Sustainable Rate of Growth

At this point, we can also relate the DDM to another important concept, the sustainable
rate of growth. The sustainable growth rate is the highest growth rate a firm can maintain without
resorting to external sources of funds. Let’s assume for simplicity that the firm is all equity-
financed and that all of its reinvestment comes from retained earnings (i.e., no stock or bond
issues).5 Earnings (Ei) are the product of the ROE and the book value of equity at the beginning
of the period (Bi-1). The book value of equity represents the capital resources that the firm has
invested to this point from which it hopes to generate future earnings. Typically it is assumed
that the ROE is a constant, so that

Ei = ROE  Bi-1 for i = 1, 2, . . .

In any period, earnings are the total dollars returned on the firm’s investments or capital base.
Thus, if the firm’s book capital at the beginning of the year is $1,000 and ROE is 20%, the firm’s
earnings would be $200 at the end of the year. If we also assume that the dividend payout ratio is
40% and use the relationship we defined earlier (D1 = δE1), then dividends are D1 = 0.40  $200
= $80.

We can express the book value at any time in terms of the initial book value B0. The book
value at the end of the year is the beginning book value plus the additions to retained earnings.
But what are the additions to retained earnings? In any year, the additions are simply the
earnings minus any dividends paid.

5
One can also define the sustainable growth rate as the maximum rate a firm can grow without changing its
target debt and dividend policies. These policies can affect the funds available for investment. In this case,
reinvestment opportunities are not limited strictly to internally generated funds.

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B1 = B0 + E1 − D1
B1 = $1,000 + $200 − $80 = $1,120.

Following our example, the end of period book value is equivalent to the beginning of period
book value plus retained earnings, or $1,000 + ($200 − $80) = $1,120. Note that book value
grows over the year from $1,000 to $1,120, or at a 12% rate.

Remembering that E1 = ROE  B0 and D1 = δE1, we can write

B1 = B0 + ROE  B0 -  ROE  B0
= B0 + Earnings - Dividends
B1 = B0 [ 1 + (1 -  )  ROE].

We can simplify even further by noting that the earnings retention rate or the plowback rate (PB)
is
PB = (1 − δ), and substituting PB for (1 − δ) above. Hence the end of period book value of
$1,120 is equal to 1,000  (1 + 0.60  0.20), and the growth rate g is the percentage plowback
multiplied by ROE, or 0.60  0.20 = 0.12.

As long as ROE is assumed to be constant, earnings grow at the same rate as book value.
As long as a constant dividend payout ratio is maintained, dividends grow at the same rate as
earnings. Thus, PB  ROE is the sustainable rate at which book value, earnings, and dividends
all grow. That is,

g = PB  ROE = (1 − Dividend payout ratio)  ROE.

A summary of our example follows:

Annual
1 2 Growth Rate
Beginning book capital $1,000 $1,120 12%
Earnings [ROE  Bi-1] 200 224.0 12%
− Dividends [δEi] 80 89.6 12%
Plowback [(1 − δ)  Ei] 120 134.4 12%
Ending book capital $1,120 $1,254.4 12%

To understand how the sustainable growth rate can be used, suppose a firm wants to
increase sales at a fast rate. A high growth rate in sales usually necessitates increases in
inventory, accounts receivable, and perhaps other fixed assets. But how will the firm fund this
high growth in assets? The increase in assets must be financed by an appropriate increase in
liabilities and owners’ equity. Suppose our firm has an ROE of 20% and a PB of 60%. Under the
assumptions outlined above, its sustainable growth rate is 12%. Because we have ruled out new
equity and debt issues, the sustainable growth rate represents the increase in the owners’ equity.
Liabilities can increase in proportion to owners’ equity up to a certain point, but beyond that,

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expansion is limited by the equity of the firm. Thus, the most important element in how fast a
firm can increase its assets without straining its financial capacity is dictated by the increase in
equity. If our firm wishes to increase its asset growth beyond 12%, it will have to consider
increasing its debt (financial leverage) or reducing its dividend. Either of those changes enables
the firm to grow faster than its sustainable rate of growth. However, changing the firm’s debt and
dividend policies would raise a number of important issues for management’s review. In the
absence of such changes in financial policy, the sustainable growth rate tells us how fast the firm
can grow when funding is limited to internally generated funds.

Conclusion

This note has described the dividend discount model as one approach used to determine
the value of an equity share and to estimate the required return on equity. The reliability of the
DDM depends on whether the constant growth assumptions underlying its use are met for a
particular application. We suspect that this simple model has survived because it allows analysts
to focus closely on growth, risk, and the reinvestment opportunities that firms possess in
comparison with other firms. Those factors are among the “most fundamental” of fundamentals
when it comes to valuing corporate assets. Thus, while the model is not a perfect descriptor of
reality, it helps us to reduce the range of uncertainty around key value drivers.

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