14.9: Components of the Dividend Discount Model

T he DDM formula contains several variables whose values must be ascertained in order to solve for Price ( P ). Here is the formula (again).

We must solve for “P.” The market price (P) will equal the security’s intrinsic value (V) if the security is efficiently – or correctly – priced in the market. That is what we are trying to uncover with the formula. We will assume here that P = V.

D 0 is the prior year’s dividend, and is thus a known, historical fact. D1 is the next dividend.

Next year’s dividend depends on our expected dividend growth rate, “G.”

The dividend’s growth rate is defined as:

However, w e do not know D 1 , the next year’s dividend. Therefore, we need a formula for “G.” Here, is the non-intuitive formula for G.

RR = Retention Rate = (NI – D ÷ NI) = (A.R.E. ÷ NI)

A.R.E. = Addition to Retained Earnings = NI – D

We will examine “G” more closely below and introduce “R.”