The dividend discount model is a way of valuing a company based on the theory that a stock

Stock

The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...

 is worth the discounted sum of all of its future dividend payments. In other words, it is used to evaluate stocks based on the net present value

Net present value

In finance, the net present value or net present worth of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values of the individual cash flows of the same entity...

 of the future dividends.

Dividend discount model is a tool that produces a number based on the data provided. The equation can be written as


where is the current stock price, is the expected dividend, is the required rate of return, and is the expected growth rate in perpetuity.

This equation is also used to estimate cost of capital

Cost of capital

The cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds , or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities"...

 by solving for

From the first equation, one might notice that in the long run, the growth rate cannot exceed the cost of equity

Cost of equity

In finance, the cost of equity is the return a firm theoretically pays to its equity investors, i.e., shareholders, to compensate for the risk they undertake by investing their capital. Firms need to acquire capital from others to operate and grow...

; cannot be negative, i.e., . In the short run if , then usually a two stage DDM is used:


Therefore,


where denotes the short-run expected growth rate, denotes the long-run growth rate, and is the period (number of years), over which the short-run growth rate is applied.