Dividend Discount and Residual Income Valuation Models

✦ The dividend discount model (DDM) and residual income model (RIM) are intrinsic valuation techniques that estimate equity value based on cash distributions and economic profits, respectively.

✦ DDM values a firm by discounting expected dividends, making it suitable for stable, mature companies with consistent payout policies.

✦ RIM focuses on the value created above the cost of equity, capturing the firm’s ability to generate returns in excess of capital charges—even without dividend payments.

✦ Both models rely on clean accounting data, reasonable growth assumptions, and alignment with investor-required returns.

We’ll break down how to apply DDM and RIM, when to use each, and how to interpret results for equity valuation and performance benchmarking.

1. Dividend Discount Model (DDM) — Fundamentals

The DDM estimates stock value as the present value of future expected dividends, assuming shareholders are compensated through distributions.

✦ Core Formula (Gordon Growth Model):

P₀ = D₁ / (r – g)

Where:

• P₀ = current intrinsic value of equity

• D₁ = expected dividend next year

• r = cost of equity

• g = dividend growth rate

✦ Assumes dividends grow at a constant rate, and the company operates in perpetuity.

2. Applying the DDM — Example

Assumptions

• Expected dividend next year (D₁) = $2.00

• Cost of equity (r) = 9 %

• Dividend growth (g) = 4 %

Valuation

P₀ = $2.00 / (0.09 – 0.04) = $40.00 per share

✦ If the current share price is $35, the stock may be undervalued.

✦ If the company grows faster than expected or raises its payout, intrinsic value rises.

3. When to Use DDM

✦ Best for companies that: 

• Pay regular, predictable dividends 

• Operate in stable industries (e.g., utilities, consumer staples) 

• Have long-term dividend policies tied to free cash flow

✦ Less useful for: 

• Growth companies that reinvest earnings 

• Firms with irregular or no dividends 

• Highly cyclical or restructuring businesses

4. Residual Income Model (RIM) — Fundamentals

The residual income model values equity based on the book value of equity and the present value of future residual income.

✦ Residual income = Net income – (Equity capital × Cost of equity)

✦ Formula:

Equity value = Book value + ∑ (Residual income ÷ (1 + r)^t)

✦ Captures value created from returns above required equity cost, regardless of dividends.

5. RIM Example — Step-by-Step

Assumptions

• Book value per share = $25

• Net income per share next year = $4.00

• Equity capital per share = $25

• Cost of equity = 10 %

Residual income = $4.00 – (10 % × $25) = $1.50

Assume this grows at 5 % in perpetuity:

Value of residual income = $1.50 / (0.10 – 0.05) = $30

Equity value = $25 + $30 = $55 per share

6. When to Use RIM

✦ Ideal for companies that: 

• Retain earnings or reinvest heavily 

• Have clean, reliable book value accounting 

• Operate in sectors where dividends aren’t aligned with profitability (e.g., tech, financials)

✦ Common in: 

• Equity research 

• Banking and insurance valuations 

• IFRS/GAAP impairment testing

✦ Requires stable ROE forecasts and consistent accounting treatment.

7. Strengths and Limitations

✦ DDM Strengths: 

• Direct link to shareholder returns 

• Simple to apply for high-dividend firms

✦ DDM Limitations: 

• Not useful for non-dividend payers 

• Sensitive to g and r inputs

✦ RIM Strengths: 

• Captures value creation beyond payouts 

• Works when dividends are suppressed or irregular

✦ RIM Limitations: 

• Sensitive to accounting estimates (e.g., net income, equity capital) 

• Requires long-term forecasts and terminal assumptions

8. Model Selection and Integration

✦ Choose based on payout policy, industry, and data availability.

✦ Consider using both DDM and RIM for cross-checking valuations, especially for hybrid firms that pay dividends and retain earnings.

✦ Supplement with market and DCF-based approaches for a full valuation triangulation.