In our calculator, you can input the dividend growth rate in two separate finite stages. In addition, you can input a terminal dividend growth rate that is used in perpetuity. You have the option to choose the duration of each finite stage.

I have implemented two methods to calculate the Discount Rate (Cost of Equity) that is later used in our DDM calculator.

Our Multi-Stage DDM with Gordon Growth Model Calculator User Guide with Demo

## How we calculate the Discount Rate or Cost of Equity?

**Cost of Equity or Require rate of return** is a more formal name for Discount Rate. In my DDM calculator, I have implemented two methods for calculating the discount rate.

**Manual**: In this method you can set any value as the discount rate. Manually set any desired discount rate is very useful. You can set different discount rate and compare the different calculated fair value of that stock. You can prepare yourself for many scenarios and potential outcomes for your investment.**CAPM**: Capital Asset Pricing model (CAPM) helps us understand the relationship between the risk and expected return for stocks.

**CAPM Formula**

**Beta**is the volatility of the stock. You can find beta for each stock at morningstar.com**Risk-Free Rate**is the interest/return an investor should get for zero-risk investments. Government’s long term (i.e. 10Y) treasury bond yield is considered as lowest risk. USA Risk-free rate at FRED Website**Market’s Annual Return**is the average annualised historical retrun of the stock market. Long term (20-30Y) USA stock market returns around 10%, US Historical Market Return

## What Is the Dividend Discount Model (DDM)

The Dividend Discount Model (DDM) is a method that calculates a **company’s stock price based on the sum of all future dividend payments from that company. The dividend sum is discounted back to its present value at a fair rate (discount rate or cost of equity or required rate of return).**

The discount rate factors in the time value of money risk and the loss of investment capital risk. **You should use a higher discount rate for riskier investments as a rule of thumb.** It is important to use an appropriate discount rate to calculate a stock’s fair value using the Dividend Discount Model.

Let’s give a simple example. You lend your friend 100 USD and your friend returned you the borrowed 100 USD back after 1 year. You may think that you got your money back but in reality, you lost some money.

**The purchasing power of 100 USD next year is not the same as it is this year. Because of inflation, you will not be able to buy the same amount of goods and services.** If the inflation is 10% then your friend should return you 110 USD. The present value of 110 USD is 100 USD this year if the inflation rate is 10%.

The same principle is applied in the Dividend Discount Model. The discount rate functions like the inflation rate. There are a few variations of DDM that I will discuss in the next section.

## What are different variations of Dividend Discount Model (DDM)

Based on holding time and dividend growth rate we can define a few variations of DDM as follows

- Zero-Growth DDM
- Gordon Growth Model (GGM)
- Variable Growth multi-Stage DDM

### Zero-Growth DDM

Zero-Growth DDM deals with the scenario when a stock pays the same dividend amount forever in perpetuity. You can calculate the current intrinsic value of that stock using the following simple formula

- P
_{0}= Calculated Intrinsic Value of the stock at present time - D= Annual Dividend Payment
- r = Discount Rate

### Gordon Growth Model (GGM)

Gordon Growth Mode tackles the scenario when a **stock shall pay a dividend forever that shall grow at a constant rate forever.** You can calculate the current intrinsic value of that stock using the following formula

- P
_{0}= Calculated Intrinsic Value of the stock at present time - D
_{1}= Next year’s annual Dividend payment - r = Discount Rate
- g = the constant dividend growth rate of the stock

Sometimes, it might be difficult to find the next year’s declared dividend. If you can find only this year’s dividend then you can use the following formula for constant growth DDM

- P
_{0}= Calculated Intrinsic Value of the stock at present time - D
_{0}= This year’s annual Dividend payment - r = Discount Rate
- g = the constant dividend growth rate of the stock

### Variable Growth Multi-stage DDM

Constant rate Multi-period DDM deals with the scenario when you **buy stock this year and plan to sell that stock 2 or more years later, and during this whole multi-period duration, the dividend payment from this stock had a variable growth rate.**