How does the dividend discount model differ from the discounted cash flow method

The Dividend Discount Model (DDM) and Discounted Cash Flow (DCF) method are both fundamental valuation tools, but they differ significantly in scope, application, and assumptions. Here’s a breakdown of their key differences:

1. Cash Flows Considered

• DDM: Focuses exclusively on dividends as the relevant cash flow. It assumes dividends are the primary returns shareholders receive, similar to bond coupon payments.
• DCF: Accounts for all cash flows a company generates, including free cash flow to equity (FCFE) or free cash flow to the firm (FCFF). This includes earnings reinvested in the business, debt repayments, or share buybacks.

2. Applicability

DDM

Only works for stable dividend-paying stocks

Struggles with high-growth stocks (e.g., tech startups)

DCF

Applicable to all companies, including non-dividend payers

Handles high-growth phases using multi-stage models.

3. Discount Rates

DDM: Uses the cost of equity as the discount rate, reflecting shareholders’ required return.

DCF:

For FCFF: Uses weighted average cost of capital (WACC) to account for both equity and debt.

For FCFE: Uses cost of equity, similar to DDM

4. Key Formulas

DDM (Gordon Growth Model):

Stock Value = D1 /r−g

Where

D1 = Next year’s dividend,

r = Cost of equity,

g = Dividend growth rate.

DCF (Generic Form):

Value = ∑t=1n Cash Flow / (1 + Discount Rate)^t

5. Limitations

DDM:

Fails for non-dividend stocks.
Overly sensitive to growth rate assumptions (e.g., negative values if g>rg>r).

DCF:

Requires complex cash flow projections.
Relies on accurate WACC/FCF estimates

When to Use Each Model

• DDM: Best for mature, dividend-paying companies (e.g., utilities, consumer staples) with predictable payouts.
• DCF: Preferred for growth-focused firms or those with irregular/no dividends (e.g., tech companies).

Both models aim to estimate intrinsic value but cater to different investment philosophies and company profiles.