Introduction to Dividend Discount Model
Dividend Discount Model (DDM) is a method of valuation of a company’s stock that is driven by the theory that the value of its stock is the cumulative sum of all its payments given in the form of dividends which we discount in this case to its present value. In simpler words, this method is used to derive the value of the stocks based on the net present value of dividends to be distributed in the future.
Description of Dividend Discount Model
A DDM is a valuation model where the dividend to be distributed related to a stock for a company is discounted back to the cumulative net present value and calculated accordingly. It is a quantitative method to determine or predict the price of a stock pertaining to a company. It majorly excludes all the external market conditions and only considers the fair value of the stock. The two factors which it takes into consideration is dividend pay-out factors and expected market returns. If the value obtained from the calculation of DDM for a particular stock is higher than the current trading price of the stock in the market we term the stock as undervalued and similarly if the value obtained from the calculation of DDM for a particular stock is lower than the current trading price of the stock in the market we term the stock as overvalued. In this method the base on which the dividend discount model relies is the concept of the time value of money.
Formula of Dividend Discount Model
The traditional model for dividend discount is shown below with no dividend growth
- P0 = price at time zero, with no dividend growth
- Div = future dividend payments
- r = discount rate
The above formula comes from the formula of perpetuity where we show that the company is not growing and giving out a steady dividend every year.
P0 = Div/1 + r + Div/(1 + r)2 + Div/(1 + r)3 + ……………. = Div/r
But this is not true as a company will grow over with time too and thus the dividend distribution will also grow. Thus to take into account the growth of the company too in our calculation of dividend discount model the formula get a new shape as follows:
This is also derived from the formula of perpetuity with the growth rate in consideration.
- P0 = Div/1 + r + Div(1 + g)/(1 + r)2 + Div(1 + g)2/(1 + r)3 + ……………. = Div/(r – g)
- P0 = Price at initial point of time zero with constant dividend growth
- g = Dividend growth rate
Example of a Dividend Discount Model
Following are the example of DDM are given below:
Example #1 – Zero Growth Model
Not taking into consideration that the company will grow.If a stock pays dividends of $1.50 per year and the required rate of return for the stock is 9%, then calculate the intrinsic value:
Intrinsic Value is calculated using the formula given below
DDM = Intrinsic Value of Stock = Annual Dividend / Expected Rate of Return
- Intrinsic Value = $1.50 / 0.09
- Intrinsic Value = $16.66
Example #2 – Constant Growth Rate Model
Suppose a stock is paying $6 dividend the current year, and the dividend sees a steady growth of 8% annually, then what will be the intrinsic value of the stock where we assume the expected rate of return is 10%?
Intrinsic Value is calculated using the formula given below
DDM = Intrinsic Value of Stock = Div (1+g) / (r-g)
- Intrinsic Value = 6 (1 + 0.08)/(0.10 – 0.08)
- Intrinsic Value = $324
How does DDM Work?
The dividend discount model works on the principle of the time value of money. It is built on the assumption that the intrinsic value of a stock will show the present value of all the future cash flow or the dividend earned from a stock. Dividends are always positive cash flows that are distributed by a company to its shareholders. The dividend discount model as such requires no complex calculation and is user friendly. It is the easiest way to estimate the fair stock price with minimum mathematical inputs. It helps in determining whether a stock is undervalued or overvalued based on the comparison between the number derived from the model and the current stock price prevailing in the market.
Types of Dividend Discount Model
The different types of DDM are as follows:
1. Zero Growth DDM
This is the traditional method of dividend discount model which assumes that the entire dividend paid during the course of stock will be the same and constant forever until infinite. It considers that there will be no growth in the dividend and thus the stock price will be equal to the annual dividend divided by the rate of returns.
2. Constant Growth Rate DDM
This model takes into an assumption that the dividends are growing only at a fixed percentage or on a constant basis annually. There is no variability and the percentage growth is the same throughout. This is also known as the Gordon Growth Model and assumes that dividends are growing by a fixed specific percentage each year. Constant growth models are specific to the valuation of matured companies only whose dividends have been growing steadily over time.
3. Variable Growth DDM or Non-Constant Growth
The model takes into the assumption that the growth will be divided into three or four phases. The first one will be fast initial phase, then a slower transition phase and finally ends with a lower rate for the finite period. This is more realistic when compared to the other two methods. The model solves the problem of a company giving unsteady dividends which is a true picture during the variable growth phases of a company.
Further, the variable growth rate model is further divided into several parts:
4. Two Stage DDM
Model to determine the value of equity of business with dual growth stage. There is an initial period of faster growth and then a subsequent period of stable growth.
5. Three Stage DDM
Model to determine the value of equity of a business with three growth stage. The first one will be a fast initial phase, then a slower transition phase and finally ends with a lower rate for the finite period.
Advantages and Disadvantages of DDM
Below are the advantages and disadvantages mentioned:
Advantages of DDM
The advantages are as follows:
- Proven and Sound Logic: The main concept used here is the time value of money based on the future cash flows which is nothing but the dividends. It has very little exposure to some mathematical models or assumptions which even more makes the model trust worthy.
- Consistency: Many companies pay their dividends in the form of cash and thus topic is very close to the fundamentals of a company. Thus the company will never try to manipulate this number as it can hamper their stock price volatility which means this model is a trusted one.
- Matured Business: the payment of dividends which is happening regularly always doesn’t means that the company has matured and that there is no volatility involved. Thus this model comes useful for investors who prefer to invest in a stock that pays regular dividends.
Disadvantages of DDM
The disadvantages are as follows:
- Sensitive Assumptions: As we know the fair price is very sensitive to growth rates and the rate of return required. Thus 1 % increase or decrease in our assumption of both can affect the valuation of the stock.
- May Not Be Earnings Related: Dividends should have a correlation with earnings. On the contrary companies try to have a fixed or constant dividend pay-out instead of variable pay related to the earnings.
- Specific to Mature Companies Only: Model is more specific to mature companies only and it is limited to high growth companies.
The dividend growth rate model is a very effective way of valuing matured companies. It is advantageous because it is much more reliable and proven. Since it doesn’t depend on mathematical assumptions and techniques it is much more realistic.
This is a guide to the Dividend Discount Model. Here we discuss types and how does it work along with the advantages and disadvantages of the dividend discount model. You may also look at the following articles to learn more –
- Interest vs Dividend | What is Interest and Dividend?
- Difference Between Dividend vs Growth
- Dividends vs Capital Gains Which is Better?
- Examples of Interest Coverage Ratio