If you’re investing in equity, chances are you want to calculate the equity yourself before investing. But there are so many methods for that that it gets confusing. This is why most investors tend to use the discounted dividend method.
But the problem is that while it’s fairly accurate, it’s equally complicated for beginners. This is why in this article, we have put together a guide that would help beginners master the discounted dividend method for accurate valuation.
Understanding the Core Logic of the Discounted Dividend Method
The Discounted Dividend Method (DDM) is used to estimate the true value of a company’s stock. It is based on one simple idea: a stock’s current value is the present value of all the dividends it will pay in the future.
Companies earn money by selling products or providing services. This business activity creates profits, and part of these profits is often shared with shareholders in the form of dividends. Since dividends come from a company’s earnings, they reflect the company’s financial health and performance.
The Discounted Dividend Method focuses only on these future dividend payments. It calculates how much all expected future dividends are worth in today’s terms. This helps investors understand what a stock should be worth, regardless of short-term market movements.
Once the fair value is calculated, investors compare it with the stock’s current market price:
- If the DDM value is higher than the market price, the stock is considered undervalued, and it may be a good time to buy.
- If the DDM value is lower than the market price, the stock is considered overvalued, and it may be better to sell.
In short, the Discounted Dividend Method helps investors decide whether a stock is cheap or expensive by converting future dividends into today’s value and comparing that number with the current share price.
Breaking Down the Gordon Growth Formula Step by Step
The Gordon Growth Model is the simplest form of the discounted dividend method, so if you want to start with this method, the Gordon Growth Model is actually the best way to go around.
The formula for the Gordon growth model uses the math of an infinite series of numbers that all grow at the same pace. The model’s main inputs are the dividends per share (DPS), the pace at which those dividends rise, and the rate of return (ROR) that is needed.
P = D1 / (R – G) where:
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Getting the Inputs Right: Dividends and Cost of Equity Made Simple
For the Discounted Dividend Method value to be accurate, the quality of the input is much more important than the arithmetic itself. The two most important inputs, dividends and cost of equity, ought to be based on real business facts, not wishful thinking. The table below clearly explains both of them in a way that is easy for beginners to understand.
| Area | What to Do | Why It Matters | Common Red Flags |
| Dividend Base | Start with normalised, sustainable dividends | One-off or inflated payouts distort value | Sudden spikes from asset sales |
| Irregular Dividends | Adjust or average historical payouts | Smooths volatility for realism | Treating special dividends as recurring |
| Payout Ratio Check | Compare dividends to earnings forecasts | Ensures dividends are affordable | Payouts exceeding long-term earnings |
| Dividend Growth | Link growth to business fundamentals | Dividends can’t outgrow profits forever | Growth higher than revenue/ROE trends |
| Cost of Equity (r) | Use CAPM as a structured guide | r is the most sensitive Discounted Dividend Method input | Small errors cause large valuation swings |
| Risk-Free Rate | Use current long-term government yields | Reflects today’s opportunity cost | Using outdated or short-term rates |
| Beta | Adjust for leverage and cyclicality | Captures true business risk | Blindly using raw historical beta |
| Equity Risk Premium | Stick to market-based, conservative ranges | Anchors expectations to reality | Overly optimistic return assumptions |
| Cross-Check | Compare r with industry peers | Catches modelling blind spots | Cost of equity far from sector norms |
Choosing the Right Discounted Dividend Method Variant for Different Businesses
Now, there are multiple dividend models that you can choose from, but each dividend model doesn’t fit the other, which is why you need to pick the accurate Discounted Dividend Method variant for the accurate use case. For instance:
- The Gordon Growth Model, also called the single-stage Discounted Dividend Method we just talked about, works well for businesses that are already established, stable, and have consistent dividends, such as utilities, consumer staples, or regulated companies. Its simplicity is a good thing, but it stops working if growth or rewards change a lot.
- However, there’s a two-stage Discounted Dividend Method that is appropriate for businesses that are growing faster than average right now but are likely to settle into a stable phase. This method predicts dividends explicitly during a time of high growth (usually 5 to 10 years), and then it uses a low perpetual growth rate to find the terminal value.
- Lastly, by representing acceleration, transition, and maturity independently, the three-stage Discounted Dividend Method makes things even more genuine. This is helpful for organisations that go through cycles, banks or companies that are changing from periods where they have to reinvest a lot of money to ones that pay regular dividends.
Each method isn’t suited for the other type of company. As a beginner, you must start with the Gordon Growth Model, as it works with almost any company on the stock market.
Conclusion
The discounted dividend method is the most reliable when it comes to calculating the equity of a stock. Learning this method can quickly take you from a beginner to an intermediate investor and allow you to move on to the expert level in no time. With this guide, you can quickly master the method and invest in equity in a much better way.