What is the Dividend Discount Model?

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  • 20 Dec 2023
What is the Dividend Discount Model?

Key Highlights

  • The Dividend Discount Model (DDM) is a conservative method for valuing stocks. It determines a stock's worth by considering the present value of its anticipated future dividends.
  • Different types of DDM include Zero Growth DDM, Gordon Growth DDM (constant growth), Two-Stage DDM, and Three-Stage DDM.
  • The model has limitations, such as its reliance on dividend payouts, making it unsuitable for evaluating stocks that don't pay dividends.

The Dividend Discount Model (DDM) is widely accepted as one of the most conservative methods to value stocks. In the Dividend Discount Model, a stock is worth its price if its present value exceeds the estimated net present value of future dividends.

It is based on many assumptions, such as future dividend payments, growth patterns, and interest rate trends. Using DDM, stocks are valued based on their net present value of dividends to come. Stock values are calculated by taking the sum of the future cash flows the firm expects to generate, and discounting them by a risk-adjusted rate. The dividends can be used to determine how much cash is returned to shareholders.

Under the dividend discount model (DDM), the implied stock price is calculated as follows. Intrinsic Value Per Share = D1 ÷ (ke - g) Where: D1 = Expected Dividend in Next Year ke = Cost of Equity g = Growth Rate of Dividend

Here are the different types of DDM:

1. Zero Growth Dividend discount models assume that the dividend growth rate (DGR) remains constant throughout perpetuity, and the share price equals the annualised dividend divided by the discount rate.

2. Gordon Growth DDM It is often called the constant growth DDM. This variation assigns a perpetual DGR with no change throughout the entire period of the forecast.

3. Two-Stage DDM DDMs determine the share price of a company based on a two-stage forecast: an initial period of increasing dividend growth, followed by a stable dividend growth period.

4. Three-Stage DDM DDM's three-stage variation is an extension of two-stage DDM, with dividend growth rates declining over time.

The Dividend Discount Model has a few drawbacks. Here are they:

1. Dividend Payouts Necessity The first and foremost disadvantage of DDM is that it cannot be used to evaluate stocks that don't pay dividends despite capital gains that would be realised from investing in them. DDMs assume that the only value of a stock lies in its return on investment (ROI) through dividends. When assessing a number of companies, the DDM model is useless because it only works when dividends are expected to rise consistently in the future. Only fairly mature companies with dividend payment histories can be used with it.

2. Too Many Assumptions As discussed in this article, the Dividend Discount Model makes too many assumptions about dividends. These include assumptions about growth rates, interest rates, and tax rates, all of which are beyond the investor's control. A drawback like this reduces the DDM model's reliability.

3. Buyback Ignorance In addition, the DDM does not take stock buybacks into account. The stock valuation of a company changes when the company buys back shares from its shareholders. DDM is too conservative and does not account for stock buybacks, especially in countries with tax structures that make share buybacks more advantageous than dividends.

Conclusion

By comparing investments across different sectors, dividend discount models can help investors pick stocks that are overbought or oversold. It is best used for stocks with a long dividend history. However, not for stocks with a short or no dividend history. Furthermore, it is important to evaluate a variety of factors before making a final decision on any investment.

FAQs on the Dividend Discount Model

Dividend discount models have a few downsides, including their lack of accuracy. A major limitation of the DDM is that it can only be used with dividend-paying companies. Additionally, the DDM does not consider stock buybacks, which makes it too conservative.

Using the Dividend Discount Model, an investor can evaluate several assumptions about a company's growth and future prospects. The DDM shows that a company's value is determined by its total future cash flows discounted to its present value.

In the DDM, the fair value of a stock is calculated regardless of current market conditions. If the DDM value is greater than the current stock price, then the stock is undervalued and should be purchased. The opposite is true if the DDM value is lower.

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