The value of any asset must equal the present value of its future cash flows, discounted at a rate that reflects its inherent risk. Since neither the future cash flows nor the appropriate discount rate can be known with certainty, valuation is inherently an estimation.
In a dividend discount model (DDM), dividends are assumed to be the primary cash flow for an investor in a stock. Even when the investor plans to sell the stock at a future date, the value at that time will be the present value of any subsequent dividends, so a discounted dividend approach should still be valid. Still, for companies that do not pay dividends other methods may be more appropriate. The DDM is most appropriate for use when:
- The company pays a dividend
- The dividend policy has an understandable and consistent relationship to profitability
- The investor does not plan to gain full control of the company