The dividend discount model provides a means of developing an explicit expected return for the stock market. By comparing this return with the expected return on bonds, as derived from a yield to maturity calculation, the investor can calculate a return spread between these two classes of securities that can be used to assess the relative attractiveness of each. Investors can also use these return data, along with risk data, to determine an optimal blend of assets—stocks, bonds, money market instruments or real estate—within an asset allocation framework.
Elaborations on the simple dividend discount model provide an important tool for comparing relative values across a sample of individual stocks. Returns derived from complex models may be combined with risk data to construct a “market line” benchmark. Securities that plot along the line may be considered fairly priced; those that plot below the line would be considered relatively unattractive; and securities that plot above the line presumably offer more return than would be expected, given their riskiness.
The dividend discount model may also be modified to provide an estimate of a stock’s duration—its sensitivity to interest rate risk. Inasmuch as the measure of duration for stocks is similar to the measure of duration for bonds, stock and bond durations may be compared to determine the assets’ relative sensitivity to interest rate changes. Similarly, the model provides a framework for comparing the sensitivities of stocks and bonds to unexpected changes in inflation rates.