In the dividend discount model (DDM), the value of a stock is primarily determined by which of the following?

• A. The market price of similar stocks
• B. The company's historical dividend payments
• C. The book value of the company's assets
• D. The present value of all expected future dividends

Answer: (D)

Verified step by step guidance

1. Understand the Dividend Discount Model (DDM): The DDM is a method used to value a stock by calculating the present value of all expected future dividend payments. It assumes that dividends are the primary source of value for shareholders.
2. Identify the key formula for DDM: The general formula for the DDM is \( P_0 = \frac{D_1}{r - g} \), where \( P_0 \) is the current stock price, \( D_1 \) is the expected dividend in the next period, \( r \) is the required rate of return, and \( g \) is the expected dividend growth rate.
3. Clarify the components: \( D_1 \) represents the future dividend, \( r \) reflects the investor's required rate of return (often based on risk and market conditions), and \( g \) is the growth rate of dividends over time. These components are essential for determining the stock's value.
4. Explain the concept of present value: The DDM calculates the present value of future dividends by discounting them back to today using the required rate of return. This reflects the time value of money, where future cash flows are worth less than immediate cash flows.
5. Conclude the primary determinant: The value of a stock in the DDM is determined by the present value of all expected future dividends, not by market price, historical dividend payments, or book value of assets.