Dividend discount model is defined as a method through which one can calculate the price of a stock by discounting the present value of the dividend which is paid by the company to its shareholders. The formula for calculating the value of a stock through this method is
Value of a stock = Dividend paid by the company/Required rate of return – Dividend growth rate
Dividend discount model can be better understood with the help of an example. Suppose a company pays a dividend of $5 per share and required return by the shareholders is 15 percent and growth rate of future dividend is 5 percent then putting all this figures into the formula we get the share price of a stock, that is 5/15 % – 5 % = $50 per share.
The above procedure for calculating the value of a stock is called constant growth model that it can be used only when growth rate is assumed to be constant. There are many variants of dividend discount model and therefore for valuing different companies different variant can be used. However this method cannot be used for valuing those companies which are just entering into the business and pay zero dividends.