Introduction
The dividend discount model (DDM) is a quantitative method for predicting the price of a company’s stock based on the theory that its present-day value equates to the sum of all its future dividend payments, discounted back to their present value.
It aims to calculate the fair value of a stock irrespective of current market conditions, taking into account dividend payout factors and expected market returns. If the calculated DDM value is higher than the current trading price, the stock is undervalued and worth buying, and vice versa.
Key Takeaways
- The DDM is a mathematical means of predicting the price of a stock based on expected future dividends.
- Reflects the principle that a stock’s current price is equivalent to the sum of future dividends discounted back to the present value.
- It aims to calculate the intrinsic value of a stock, regardless of prevailing market conditions.
- Stocks are considered undervalued if the DDM value exceeds the current stock price, signaling a potential buy opportunity.
Understanding the Dividend Discount Model
Companies produce goods or services to earn profits, reflected in stock prices. Profit distribution to stockholders in the form of dividends forms the foundation of the DDM. The model theorizes that a company’s value is the present worth of all its future dividend payments.
Importance of Time Value of Money
Explanation with Example
Imagine you lent $100 to a friend interest-free. Later, they offer you two repayment options:
- Take your $100 now.
- Take your $100 after a year.
Most individuals prefer the first option because they can invest the $100 and earn additional interest, say 5%, growing it to $105 in a year. Mathematically:
Future Value = Present Value * (1 + interest rate %)
Hence, the time value of money proves that money’s value changes over time. By knowing the future value, the present value can be calculated using the same interest rate model:
Present Value = Future Value / (1 + interest rate %)
The DDM leverages this principle by taking the expected value of future company cash flows (dividends) to calculate its Net Present Value (NPV).
Calculating Expected Dividends
Estimating future dividends requires analyzing trends or assumptions based on past payments. One assumption may be a fixed growth rate in dividends into perpetuity. For instance, a company paying $1 per share with a 5% expected growth will pay $1.05 next year.
Alternatively, consistent past dividends can predict future payments. If a company paid dividends of $2.00, $2.50, $3.00, and $3.50 in the last four years, estimating this year’s payment as $4.00 becomes logical.
Determining the Discounting Factor
Stock investments come with risks, and investors expect returns as compensation, known as the required rate of return. Firms’ cost of equity capital signifies this rate and represents the discounting factor in DDM calculations. Investors assume risk analogous to earnings from rented properties.
Formula for DDM
The DDM formula:
Value of Stock = Expected Dividend per Share / (Cost of Capital Equity - Dividend Growth Rate)
Where:
* EDPS: Expected Dividend per Share
* CCE: Cost of Capital Equity
* DGR: Dividend Growth Rate
Variations of the DDM
There are many DDM variations, differing in accuracy and complexity. The Gordon Growth Model (GGM) is a common iteration assuming a stable dividend growth rate. The GGM calculates:
Price per Share = (Next Year's Estimated Dividend) / (Cost of Capital Equity - Growth Rate)
Additionally, a supernormal growth model exists, allowing for an initial high-growth period followed by lower constant growth.
Examples of the DDM
Example 1:
Company X paid $1.80 per share this year. With dividends growing at 5% yearly and a cost of equity capital at 7%, next year’s expected dividend is:
D₁ = $1.80 * (1 + 5%) = $1.89
Price per Share = $1.89 / (7% - 5%) = $94.50
Example 2:
Walmart Inc. paid annual dividends of $2.08, $2.12, $2.16, $2.20, and $2.24 from 2019 to 2024. The estimated average growth of 2% predicts a 2024 dividend of $2.28. Assuming a 5% rate of return:
Intrinsic Value = $2.28 / (5% - 2%) = $76.00
Limitations of the DDM
- Constant Growth Assumption: Safe for mature companies but inadequate for newer companies with fluctuating dividends or no dividends.
- Sensitivity to Inputs: Small changes greatly affect outcomes, leading to inconsistent valuations.
- Unsuitable Return Rates: DDM fails when dividend growth exceeds returns.
Using the DDM for Investments
The DDM, especially the GGM, allows investors to value stocks independent of market conditions and compare them across sectors. However, it should be used alongside other valuation tools for comprehensive analysis.
Types of Dividend Discount Models
- Gordon Growth Model (GGM)
- Two-stage Model
- Three-stage Model
- H-Model
DDM Calculation Method
The computation boils down to intrinsic value = Sum of Present Value of Dividends + Present Value of Stock Sales Price.
25% Dividend Rule
If a dividend is 25% or more of the stock’s value, the ex-dividend date is deferred to one business day after the dividend is paid.
Conclusion
The dividend discount model (DDM) helps in identifying fair stock values and making investment decisions across varying market sectors. It is particularly suitable for companies with long histories of dividend payouts. However, diversify your investment valuation strategies by combining DDM with other tools for a balanced approach. Keep in mind that numerous factors should guide your final investment decisions.
Related Terms: Dividend, Discounting, Cash Flow, Time Value of Money, Gordon Growth Model.
References
- Fidelity. “Dividends, Earnings, and Cash Flow Discount Models”.
- Food and Agriculture Organization of the United Nations. “Chapter 6—Investment Decisions—Capital Budgeting: d) Perpetuities”.
- Harvard Business Review. “Does the Capital Asset Pricing Model Work?”
- The International Financial Reporting Standards Foundation. “Illustrative Examples to Accompany IFRS 13 Fair Value Measurement: Unquoted Equity Instruments Within the Scope of IFRS 9 Financial Instruments”. Page 39.
- CFA Journal. “Limitation of Dividend Valuation Models: Lost of Limitation Dividend”.
- Myron J. Gordon. “The Investment, Financing, and Valuation of the Corporation”, R.D. Irwin, 1962.
- Walmart. “Full Dividend History”.
- Stern School of Business, New York University. “Dividend Discount Models”, Pages 1-2, 17.
- Investor.gov. “Ex-Dividend Dates: When Are You Entitled to Stock and Cash Dividends”.
