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Introduction: Mr. Valuation Explains the Discounted Dividend Method (DDM)

Hello, fellow investors! Chuck Carnevale here—many know me as Mr. Valuation. Today, I want to walk you through the Discounted Dividend Method (DDM) in clear, straightforward language. Let’s take a closer look at this widely used tool for making informed, intelligent investment decisions.
 

What Is the Discounted Dividend Model? (And Why Should You Care?)

Let me cut straight to the chase: The discounted dividend method, or DDM dividend discount model, is promoted as a powerful, widely utilized formula theoretically designed to help you determine the fair value of a dividend-paying stock. Its purpose is to be simple, logical, and claims that it can save you from overpaying for a company or missing out on a wonderful opportunity.

You know my mantra:

“Price is what you pay; value is what you get.”

The DDM claims to help you figure out what you should pay. With this paper, I will evaluate the benefits and flaws of the dividend discount model (DDM).

Therefore, I consider the goal of the dividend discount model (DDM) a very worthy objective. However, at the same time, I find a lot of fallacies and/or arbitrary inputs that cause me to challenge the validity and accuracy of this formula in real-life practice. With that said, I would prefer investors attempting to utilize the discounted dividend method over not attempting to define intrinsic value at all. On the other hand, there are so many arbitrary inputs that can be applied that in practice could mislead investors.

So let us look at the formula itself.
 

The DDM Formula—Straight from Mr. Valuation’s Desk

Here’s the classic version of the DDM, also known as the Gordon Growth Model:

[P = \frac{D1}{r – g}]

Where:

• P: The fair value (price) of the stock today
• D1: The expected dividend in the next year
• r: Your required rate of return (the minimum yield you demand for your capital)
• g: The annual dividend growth rate you reasonably expect

Translation:

You’re attempting to calculate the present value of all future dividends, assuming they’ll grow at a constant rate. In other words, how much should you pay now for a stream of income that grows over time?
 

How to Use the DDM Dividend Discount Model—Step by Step

Let’s walk through it together, just like I do in my FAST Graphs® videos:

1. Find the Next Year’s Dividend:
   Say Company A just paid a $2.00 dividend and has a solid history of growing it 5% per year.
   So next year’s dividend (D1) will be:
   $2.00 × 1.05 = $2.10
2. Set Your Required Rate of Return:
   Let’s say you’re looking for 8% (0.08) annually.
3. Estimate Dividend Growth:
   You’re comfortable assuming the 5% (0.05) growth will continue.
4. Plug the Numbers Into the Formula:
   [P = \frac{2.10}{0.08 – 0.05} = \frac{2.10}{0.03} = 70]
   So, $70 is your fair value estimate.
   If the stock trades at $60, you’ve got a margin of safety. If it’s $80, you might want to wait for a better price.
    

Mr. Valuation’s Practical Tips

• DDM works best for mature, reliable dividend payers.
  Think blue chips, not speculative growth names.
• Dividend growth and required return must be reasonable.
  Overly rosy projections can lead you astray—conservatism is your friend.
• Rising payout ratios, declining businesses, or inconsistent dividend histories?
  The DDM isn’t your best tool. Use it where it fits.
• Use it as a guide, not gospel.
  No single formula can account for everything. Combine this with thorough fundamental analysis.
   

Summary and Valuation Perspectives

Any calculation of fair value or intrinsic value does require that assumptions must be made. However, understand that the only thing certain about the future is uncertainty. Therefore, the more controlled or reasonable those assumptions can be made, the more relevant and useful the calculation becomes.

Regarding the Dividend Discount Model (DDM), my primary criticisms are as follows. Academics love the concept of required rate of return. As a value investor, I am more concerned with receiving a full measure of value from the business I invest in. To me, the real essence of fair value is when the investment is made at a price (valuation) that empowers the investor to participate fully in the operating growth of the business being invested in. If that number is at least equal to—or preferably higher than—the required rate of return, all the better. The point is, if the required rate of return is significantly less than the business can generate on shareholders’ behalf, this would imply overpaying for the business.

I also take exception with formulas that talk about calculating things in perpetuity. To my practical mind, that is an aggressive and unrealistic assumption. Discounting at the so-called riskless rate is also, in my mind, capricious and arbitrary. Instead, I prefer utilizing a discount rate that is more applicable under real-world circumstances and in the stock market.

The 15 P/E ratio, or an earnings yield of 6.67%, represents the lower end of the average 6% to 8% rate of return that stocks have delivered over more than 200 years. Consequently, I consider it a realistic and conservative rate with which to discount future cash flows at.

With that said, the FAST Graphs fundamentals analyzer software tool calculates intrinsic value based on earnings growth and uses a standard 6.67% discount rate (the inverse of the 15 P/E ratio), which in the real world represents a fair value for most publicly traded businesses. As a result, every FAST Graph presents a real-world historical back test revealing whether the logic is valid or not. Each FAST Graph is fundamentally based on a discounting future cash flows or earnings foundation. Consequently, it provides a very realistic view of the true value of the business being reviewed.

Nevertheless, the FAST Graph research tool and the dividend discount model (DDM) will often produce very compatible results.
 

Final Thoughts from Mr. Valuation

Remember—valuation matters. A great company is only a great investment when you buy it at a rational price. The Discounted Dividend Method (DDM) gives you a reasonably rational, disciplined framework for making those decisions. Use it wisely, and you’ll stack the odds of long-term investing success squarely in your favor.

However, the FAST Graph research tool already produces discounted cash flow analysis for you.

To summarize:
Invest with discipline, seek value, and never forget:

“Price is what you pay; value is what you get.”
—Chuck Carnevale, Mr. Valuation

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