The dividend discount model provides a stock price valuation based on expected future cash flows from dividends, similarly to the DCF model. The main difference is that the cash flow/dividend growth rate is constant in the DDM model where it is not in the DCF model.
How Does the Dividend Discount Method Work?
In general, the formula for valuing a stock using the dividend discount model can be expressed below.
DDM Formula:
The Value of the Stock = (Expected Dividend per Share) / (Cost of Capital Equity – Dividend Growth Rate)
OR
DDM stock valuation = CF / (r – g)
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Before using this formula, it is important to take a closer look at some of the assumptions that are made in writing it. These assumptions include:
- CF: The exact dividend that will be distributed per share
- r: The overall discount rate of the dividend and equity
- g: The dividend growth rate will be constant
Therefore, it is important to take these assumptions into account when using the dividend discount model.
Key Assumptions in DDM
There are key assumptions in the DDM model:
- Dividends are projected to be constant and reliable.
- Dividends grow at a constant rate indefinitely.
- Companies consistently pay dividends (this doesn’t work with companies that don’t pay dividends such as Google).
- Dividends are not manipulated/paid at the discretion of management.
This model is best used with Utilities and Preferred Stock as most companies pay dividends at a constant growth rate.
How Do You Figure Out the Expected Dividends?
Estimating the future dividends that a company might distribute can be complicated. Numerous analysts and investors will try to make accurate assumptions about the expected dividends that a company will pay based on the past history of that company and similar companies in the industry.
Keep in mind that there are some companies that do not necessarily pay a dividend at all. Some investors may assume that the company will pay a dividend once it reaches a certain point, that is not guaranteed.
Generally, using this formula, investors use the past dividend calendar as a way to predict future dividend payments. Most companies will increase the size of their dividend in line with the company’s growth rate. For example, if a company has a history of paying approximately $2 per share in dividends, and the company is expected to grow at a rate of 6 percent per year, then it should be safe to assume that the dividend payment next year is going to be $2.12.
On the other hand, there are some companies that consistently increase the size of their dividend payment regardless of its growth rate. For example, if a company has been gradually increasing its dividend from $1, then $1.10, and $1.20 during the past 3 years, then it only makes sense that the company is probably going to increase its dividend payment to $1.30 next year. Again, this is not guaranteed, but these assumptions will be worked into the formula when using the dividend discount method.
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What Is the Discounting Factor?
Generally, companies that pay dividends do so at an annual rate. This rate is usually represented by g, and the discounting factor for the company’s dividend is the rate of return minus that dividend growth rate, which is r – g.
The dividend growth rate is usually estimated by multiplying the retention ratio by the return on equity, or ROE. The earnings generated by the company dictate the size of the dividend payment, so the dividend payment cannot exceed the earnings of the company. Otherwise, the model will be inaccurate, as it will return a negative stock price, which is not possible.
An Example of the Dividend Discount Method
So, based on all of this information above, it might be helpful to take a look at an example of the dividend discount method in action.
Let’s assume that Company A paid a dividend of $1.50 per share this year. The company expects that its dividends are going to grow at a rate of 4 percent per year. The overall cost of equity capital is 6 percent.
If you wanted to estimate the value of the company this year, you would simply use the DDM formula to calculate the value right now:
$1.50 / (0.06 – 0.04) = $75 per share.
You could potentially use this number to figure out whether the company is overpriced, underpriced, or fairly priced. This information could be used to drive your investment decisions.
You could also use this model to estimate the value of the company next year. For example, using the dividend growth rate above, you could theoretically estimate that the dividend next year is going to be:
$1.50 x (1 + .04) = $1.56
Then, using the same formula above, you could estimate the price of that company per share:
$1.56 / (0.06 – 0.04) = $78 per share.
You can use this information to estimate and track the growth of a company over time. Then, you can compare these numbers to what actually happens and use the information to drive your investment decision.
Are Dividend Growth Rates Constant?
This formula is very straightforward, and you can use it to estimate the value of specific companies. One shortcoming of the formula is that it assumes that the dividend growth rate is going to be constant. While it might be a safe assumption for very mature companies, this assumption might not be safe for new companies that have fluctuating dividend payments. Keep in mind that as you make more assumptions, the precision of the model decreases.
DDM Stock Valuation Calculator
Try our Dividend Discount Model (DDM) calculator below:
