Dividend Discount Model (DDM)
Definition
The dividend discount model values equity as the present value of expected future dividends, discounted at the cost of equity. Its simplest form is the Gordon growth model: value = D1 / (ke − g), where D1 is next year's dividend, ke the cost of equity, and g a constant perpetual growth rate (which must be below ke).
Multi-stage DDMs project dividends explicitly for several years, then apply a terminal value via Gordon growth or an exit multiple. For banks and insurers, practitioners often use a variant that discounts distributable capital — earnings not needed to fund RWA growth and maintain target capital ratios — rather than declared dividends alone.
The DDM is the standard intrinsic-valuation method for financial institutions because a bank's 'free cash flow' is ill-defined (debt and deposits are operating items, capex is trivial, and capital requirements bind distributions), making a dividend/capital-return-based model more meaningful than an unlevered DCF.
Why interviewers ask
'Why do you use a DDM instead of a DCF for a bank?' is a canonical FIG technical — the graded answer covers why unlevered FCF breaks down for banks and how capital requirements determine what is distributable. The Gordon growth formula and its ke > g constraint are also fair game as quick math.
Related terms
Interviews don't test definitions — they test recall under pressure.
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