The dividend discount model is a quantitative method of valuing a company’s stock price. This fundamental tool is used by investors to estimate the intrinsic value of the stock based on its dividend payout.
It is one of the oldest methods of valuing stocks, and it applies financial theory in a practical approach. As per DDM, a stock is worth its price if that price exceeds the net present value of its estimated current and future dividends. This method takes into consideration the dividend payout factors and market-expected returns.
If the current trading price of shares is higher than the value determined by the DDM, then the stock is overvalued and qualifies for a sale, and vice-versa.
Dividend Discount Model Formula
Value of stock = D1/ (r - g)
where,
• D1 is the expected dividend for the next period
• r is the constant cost of equity
• g is the growth rate for dividends
Dividend Discount Model Variations
There exist different variations of DDM, which are,
1. Gordon growth model
This method is identified as the constant growth dividend discount model. This is a popular straightforward method developed by Myron J. Gordon of the Massachusetts Institute of Technology.
This model assumes that dividends grow at a fixed percentage and are consistent. The growth is presumed to be constant. This method is mostly used to value stocks of stable and mature companies with less or no fluctuations in their cash flows and ultimately to their dividend payout rate.
This model assumes that the growth rate of dividends is constant. However, in reality, the actual dividend payout increases each year. With this assumption, an investor can arrive at the present value of the stream of dividends.
The formula is,
Intrinsic value= D1 / (k-g)
where,
• D1 is the expected annual dividend per share
• k is the required rate of return
• g is the expected dividend growth rate
Zero-growth dividend discount model
As the name suggests the zero growth dividend discount model assumes that there is no growth in dividends which means the dividend always stays the same. Here the stock price would be equal to the annual dividends divided by the expected rate of return.
The formula is,
Intrinsic value of stock = Annual dividends / Rate of return
One-period dividend discount model
This variation is also known as Single period DDM and assumes that the investor wants to determine whether the intrinsic stock price will hold for one year only. The holding period is short the cash flow expected to be generated by the stock is the single divide and payment and the selling price of the respective stock.
The formula is,
V0 = D1/1+r + P1/1+r
where,
• V0 is the current fair value of the stock
• D1 is the dividend payment in one period from now
• P1 is the stock price for one period from now
• r is the estimated cost of equity capital
Multi-period dividend discount model
In this model, it is assumed that the investor will hold the stock for more than one period. Thus this formula is an extension of the single or one-period DDM. Here different growth rates can be applied to different time periods and it is used to estimate the present-day stock value based on dividends paid into an infinite number of time periods.
The formula is,
V0 = D1 / (1+r)¹ + D2 / (1+r)²+ . . . . + Dn / (1+r)ñ + Pn/(1+r)ñ
Flaws in the DDM method
While the DDM methods are widely used, it has a few well-known shortcomings, which are
• Dividend payout compulsion
One of the first drawbacks of this model is that it is applied only to those companies which pay out dividends despite their capital gains. The DDM method assumes that the return on investment it provides through dividends is the only value of a stock. This model only works when dividends are expected to rise at a constant rate in future which makes it of no use many times.
• Based on assumptions
The model itself is based on too many assumptions regarding the dividends, growth rate, interest rate, and tax rate, which are beyond the control of an investor, making it a big drawback of the DDM model. One of the main assumptions made by this model is that it assumes a constant dividend growth rate in perpetuity.
• Sensitivity to inputs
Sensitive to the changes required in the rate of returns and growth rate. The output here is super sensitive to the inputs.
• Unfit for specific companies
This model does not fit the companies where the rate of return is lower than the different growth rates. This happens if the company continues to pay dividends even after entering a loss or relatively low earnings.
Conclusion
The dividend discount model popularly known as the DDM helps the investors to pick stock by determining whether the stock is oversold or overbought. In DDM future dividend payments are discounted at their present value when computing their value today making it helpful for the investors.
This popular tool to value a company’s stock price based on a future dividend payment works on assumptions made on the growth rate, interest rate, and tax rate and is helpful for companies which are paying dividends. Different variations of this model allow the company to accurately assess the future value of numerous companies.
This model is best for stocks with a long dividend payout history and is not suitable for stocks with no dividend or short dividend history. This model can be one of the prime factors for investors finalising whether to buy or sell a stock.