Dividend discount model

The dividend discount model (DDM) calculates the intrinsic value of a stock by discounting future dividend payments back to their present value. The formula D₁/(r - g) uses the expected dividend for the next period (D₁), the required rate of return (r), and the constant growth rate of dividends (g).

The DDM assumes that dividends will grow at a constant rate indefinitely, which simplifies the valuation process. This constant growth rate (g) is crucial as it affects the stock price calculation; a higher growth rate typically increases the stock price, while a lower growth rate decreases it.

Understanding the DDM helps investors determine whether a stock is overvalued or undervalued based on its expected future dividends. By comparing the calculated stock price with the current market price, investors can make informed decisions about buying or selling stocks.