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).
P = [D 0 (1 + G)] ÷ (R – G)
= D 1 ÷ (R – G)
The variables are:
Price = Intrinsic Value
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.
The Last Annual Dividend
D 0 is the prior year’s dividend, and is thus a known, historical fact. D1 is the next dividend.
Next Year’s Dividend
Next year’s dividend depends on our expected dividend growth rate, “G.”
D 1 = D 0 × (1 + G )
Growth Rate in the Dividend
The dividend’s growth rate is defined as:
G = ( D 1 ÷ D 0 ) – 1
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.
G = ROE × RR
ROE = Return-on-Equity = (NI ÷ Eq.)
RR = Retention Rate = (NI – D ÷ NI) = (A.R.E. ÷ NI)
A.R.E. = Addition to Retained Earnings = NI – D
Therefore:
G = (NI ÷ Eq.) (A.R.E. ÷ NI)
G = (A.R.E.) ÷ Eq.
We will examine “G” more closely below and introduce “R.”