Dividend Discount Model

The dividend discount model values a stock as the present value of all the dividends it will pay. Run in reverse, it gives the cost of equity implied by the current share price. The constant growth version is the best known form.

If dividends grow at a steady rate, cost of equity equals next year's dividend divided by the price, plus growth. A $50 stock that just paid $2.00, growing 4% a year, has a next dividend of $2.08. That is a 4.16% dividend yield, and adding 4% growth gives 8.16%. A shrinking dividend can even make the result negative.

The model needs steady dividends, so it suits utilities, banks and other mature payers. It breaks down for companies that pay nothing or whose growth is close to the cost of equity. See the Gordon growth model, the dividend growth model guide, and the FAQ on cost of equity for banks.