Chartered Financial Analyst (CFA) Level I – Cypress Towne Lake Practice Test

The dividend discount model (DDM) is specifically designed to estimate the intrinsic value of a stock by focusing on the present value of its expected future dividends. The fundamental idea behind the model is that the value of a stock is equal to the sum of its future dividend payments, each discounted back to their present value using an appropriate discount rate. This approach reinforces the notion that dividends are a primary way in which shareholders receive a return on their investment in a company.

Using the DDM, analysts can project future dividend payments based on historical trends and growth rates, then apply a discount rate to convert those future payouts into their present values. By doing so, the model provides a clear framework for determining whether a stock is overvalued or undervalued based on its current market price relative to the calculated intrinsic value derived from its expected dividends.

This method is particularly useful for companies that consistently pay dividends, as it allows investors to assess a stock's potential return on investment and make informed decisions. Therefore, the correct choice about what the DDM estimates is indeed the value of a stock by discounting predicted dividends.