There has been much said about investing and how to accurately value a particular stock or other asset. Plenty of theories exist as to how to determine the real value of an investment today. There are few models as popular as the dividend discount model (DDM) though, and this alone warrants a review of the pros and cons of the DDM.

How This Model Works

In order to make an assessment of the value of DDM you must first understand how it works. It sounds complicated at first, but truthfully it is just a mathematical equation that is supposed to produce a result for the value of a stock. Basically, one must first select a company that pays a dividend and also choose how much of a return they would like to see from that investment.

Ten percent per year is a benchmark used by a lot of people when it comes to investing. That is a pretty good and realistic goal to have. Assuming that is what you are shooting for the DDM works like this: Price equals dividends divided by rate of return minus dividend growth rate.

Price = Dividends / (Rate of Return – Dividend Growth Rate)

The purpose of using this model is to give accurate value to the stock based on what it pays out as a dividend. There are some assumptions that one must plug in to the model to make it work, but once those assumptions are plugged in all of the guesswork is done. The model will just churn out a number for what the price of the stock should be and you are on your way.

Why You Should Love This Model

There are some simple but great reasons to love the dividend discount model. Among all of the ways to value stocks it is a favorite for a variety of reasons.

Highly Conservative – This model does not try to make wild assumptions about the growth of a stock into the future because the dividend growth rate can’t be more than the rate of return for the formula to work. All it is doing is making a judgement based on what the dividend that is paid out today is and assuming that the dividend will grow at a non-outrageous level in the future. If the underlying stock actually returns more money in the form of growth then that is just a bonus on top of everything else.

Easy to Understand – Once you have the math down for this model it is easy to just plug it in and use anytime you want. You can compute the assumed value of any dividend paying stock with this model and therefore make your investment choices. It is a shortcut to getting through which stocks may be overpriced or underpriced quickly and easily.

Keeps Investors in Dividend Paying Stocks – Dividend paying stocks have consistently been shown to perform better than those that do not pay dividends, according to a number of studies. The DDM model keeps investors locked into just focusing on the dividend paying stocks and hopefully investing some in them as well.

Where The DDM Fails

Sometimes things just sound too good to be true. While the DDM is a real model and does work simply, this may also be part of what is its downfall as well. It is considered too simple for a very complex world in a lot of ways. The problem is that the stock market is a multi-faceted place and one simple mathematical formula does not explain everything that goes on there.

It is not possible to just plug a few numbers in and get the perfect investment for yourself. If that was the case people would have already done so and there would be no need for a market at all. Instead, more complex valuation models may provide more insight.

A big problem with DDM is that it requires an assumption that dividends will continue to grow at a particular rate within a company forever. That doesn’t happen very often and can greatly impact the calculations that this model comes up with. You see, while some companies can in fact consistently provide a dividend growth rate year after year, others struggle to maintain a dividend at all. Some companies even cease their dividend payments entirely.

Another thing that a lot of critics of DDM point to is the fact that it only works on dividend paying stocks. Many of the smallest companies with the greatest growth potential do not pay out dividends at all. They are too busy plowing their money back into more growth and expansion. Why would you want to completely ignore these types of stocks when there could be some very big winners in there? That is something that DDM would not allow for you to do.

Instead of viewing DDM as the end all be all of investment modeling, it is probably a good idea to use it for its original intended purpose. That is to say that you should use it as a first measuring stick to compare stocks that pay dividends. You can see if there are some that appear to be well out of whack with what the model would suggest.

While you should not base your investment decisions solely on one model like this, it may be best used as a sort of early alert system that there is something particular odd about one stock or another. If you see one that the model believes is very much underpriced, then you might want to do a little more research on that company.

It might turn out through research that the stock is in fact undervalued and would make a good investment. On the other hand, you might just undercover some issues with the company that make the value of the thing make a lot more sense now. Either way, at least you are taking the time to review the stock and see what is going on with it. That is where DDM definitely comes in to help you.

Always ponder your investment decisions carefully. Never leave your financial future in the hands of someone who has invented some great math equation. You can only use those as a starting point.