Making the Dividend Discount Model Relevant for Financial Analysts

Abstract

The traditional dividend discount model (DDM) depends on dividend forecasts that are highly uncertain. The DDM can be restated in terms of projected abnormal earnings, however, which provide a much sounder basis for pricing equities. The author shows how the restated DDM can be programmed into a spreadsheet and used as a practical pricing tool by financial analysts. He uses the spreadsheet to demonstrate the behavior of a firm’s theoretical price-to-book ratio and P/E under various scenarios and illustrates the advantages of external equity financing when a firm has abnormally profitable business opportunities.