$**$Dividend Discount Model $($DDM$)**$

The Dividend Discount Model $($DDM$)$ is a method used to value a company's stock by discounting the future dividends that the company is expected to pay to its shareholders. It is based on the principle that the intrinsic value of a stock is determined by the present value of its future cash flows in the form of dividends. The DDM is derived from the concept of the time value of money, which states that a dollar received in the future is worth less than a dollar received today.

$**$Key Components of DDM:$**$

$1.**$Dividends:$**$ The DDM focuses on the dividends paid by a company to its shareholders. These dividends can be regular cash dividends or special dividends.

$2.**$Discount Rate:$**$ Also known as the required rate of return or the cost of equity, the discount rate represents the return that investors require for investing in the stock. It reflects the risk associated with the stock and the opportunity cost of investing in alternative investments.

$3.**$Growth Rate:$**$ The growth rate of dividends is a crucial factor in DDM$.$ It represents the expected annual rate at which dividends are expected to grow in the future. This growth rate can be constant, variable, or zero, depending on the company's growth prospects.

$**$Types of Dividend Discount Models:$**$

$1.**$Gordon Growth Model $($Constant Growth Model$)$:$**$ This model assumes that dividends grow at a constant rate indefinitely. The formula for the Gordon Growth Model is:

$\backslash [$ P$\_0=\backslash$frac$\{$D$\_0\backslash$times $(1+$ g$)\}\{$r $-$ g$\}\backslash ]$

Where:

$\backslash ($ P$\_0\backslash )=$ Current stock price

$\backslash ($ D$\_0\backslash )=$ Dividend per share at time $0$

$\backslash ($ r $\backslash )=$ Required rate of return

$\backslash ($ g $\backslash )=$ Constant growth rate of dividends

$2.**$Two$-$Stage Dividend Growth Model:$**$ This model accommodates companies with a high growth phase followed by a stable growth phase. It assumes different growth rates for different periods.

$3.**$H$-$Model:$**$ The H$-$Model is a variation of the two$-$stage model that assumes a gradual transition from high growth to stable growth.

$**$Limitations of DDM:$**$

$1.**$Dependency on Dividends:$**$ DDM relies heavily on dividends as the basis for valuation. Companies that do not pay dividends or have unpredictable dividend patterns may not be suitable for DDM$.$

$2.**$Assumption of Growth Rates:$**$ DDM assumes constant or stable growth rates, which may not reflect the actual growth trajectory of a company. Fluctuations in growth rates can affect the accuracy of the valuation.

$3.**$Sensitivity to Inputs:$**$ DDM is sensitive to changes in inputs such as the discount rate and growth rate, which can impact the valuation results.

$**$Example Question:$**$

Fill in the blank:

According to the Dividend Discount Model $($DDM$),$ the intrinsic value of a stock is determined by discounting the future $\_\_\_\_\_\_\_\_\_\_\_\_\_$ that the company is expected to pay to its shareholders.

A$)$ Earnings

B$)$ Cash flows

C$)$ Dividends

D$)$ Assets

Which of the following choices correctly fills in the blank in the statement?

A$)$ Earnings

B$)$ Cash flows

C$)$ Dividends

D$)$ Assets