How to Find a Stock's Value Using the Dividend Discount Model
One of the most elusive questions in investing is, "What is the right price for this stock?"
There are a number of ways to calculate a stock's value, but one of the most elegant and relatively simple ways continues to be via the dividend discount model (DDM) individual investors can estimate the price they should be willing to pay for a stock or determine whether a given stock is undervalued or overvalued.
What Is the Dividend Discount Model?
The dividend discount model starts with the premise that a stock's price should be equal to the sum of its current and future cash flows. This is after taking the "time value of money" into account.
Estimating Current & Future Cash Flows
The cleanest and most clear-cut measure of cash flow is the dividend (the mechanism companies use to pay their investors). People invest in companies with the intention of getting their money back – and then some. Dividends are one of the main ways companies return money to investors. They're paid out in cash and are the most straightforward estimate of the future cash you can expect to receive.
Even if a company doesn't pay a dividend right away, the price of its stock is calculated under the assumption that – at some point in time – the company will begin paying one. If there is no hope of ever getting money back, investors would have no reason to buy a stock. It would be worth nothing.
The Time Value of Money
Investing is a method of saving. Because you have extra money left over after paying your expenses, you can set it aside for future use. The whole point of investing is to turn a sum of today's money into a larger sum in the future.
Time value of money is a series of concepts that allows you to compare different options: Is it better to receive $24,000 today or $25,000 one year from today? If you understand the concept of present value, you can easily perform a calculation and come up with the right decision.
The time value of money is directly relevant to the dividend discount model because the DDM's main objective is to put future cash flows into today's dollars. To do so, we use present value calculations.
How to Use the DDM Formula
The dividend discount model is based on a basic valuation model which is the foundation for many other investing techniques. This basic valuation principle combines expected future cash flows and the time value of money into one easy-to-use formula:
Stock Price = the Sum of the Present Value of All Future Dividends
Or, more precisely,
Price = ∑ (Dt / (1 + r)t)
t = period
Dt = dividend during period t
r = required rate of return on the stock
If you don't understand the concept right now, it should get easier after looking at a couple of examples.
Stock ABC pays a $3 annual dividend. We decide that we must make 5% annually for this investment to be worth our while. This is known as the required rate of return/discount rate (or "r" in this tutorial). We're planning on holding the stock for the very long term.
Luckily, when we talk about an infinite holding period and a constant dividend, the DDM simplifies to this formula:
Stock Price = D / r
To calculate the price of Stock ABC, we plug in the numbers to get:
Stock Price = $3 / (0.05) = $60
This formula tells you that if you buy at $60, the $3 annual dividend will ensure you receive a 5% return on your investment. If Stock ABC is trading below $60 right now, it's a buy. If it's trading above $60, we should wait for the price to come down.#-ad_banner-#Note that this model could be used for any asset that throws off a constant stream of cash flow. For example, assume you've found a commercial property, and the tenants just signed a lease to pay $100,000 per year for an unlimited term. If you want to make a 5% return on your investment, then the property is worth $100,000 / 0.05 = $2,000,000.
Growing Dividends in the Real World
Calculating the value of a stock using the dividend discount model is easy if we assume the dividend will never change and we'll hold the stock forever. In the real world, however, most investors expect companies to grow dividends. So let's look at another example.
Factoring in Dividend Growth
What happens if Stock ABC has potential to grow its dividend? This isn't an unreasonable assumption: As long as a company can grow its earnings, it should be able to grow its dividend. You reason that Company ABC can grow its dividend by 2% every year.
Adding this growth assumption gives us the "reduced form DDM" with the following formula:
Stock Price = D1 / (r - g)
D1 = the dividend at year 1
g = the dividend growth rate
To calculate the dividend at year 1, all we need to do is multiply the current dividend ($3) by the dividend growth rate (2%): D1 = $3 x (1 + 0.02) = $3.06. Now we can plug it into the formula with the rest of our assumptions:
Stock Price = $3.06 / (0.05 - 0.02) = $102
Note: If Stock ABC is able to grow dividends by 2% per year ($102 vs. $60), it's far more valuable.
Pros and Cons of the Dividend Discount Model
The calculation gets more and more complicated as you add other assumptions. For example, what if you only want to hold the stock for 1, 5, or 10 years? What if the dividend growth rate is expected to change over time? What if the company doesn't pay a dividend yet?
For now, let's look at the pros and cons of the DDM to gain greater insight into its benefits and limitations:
Advantages of DDM
The main advantage of the dividend discount model is that it is relatively easy to use. There are only a few calculations involved. This model is a good starting point for valuing stocks, since it connects dividend payments and dividend growth to the stock price.
The dividend discount model works best for companies that are experiencing stable growth. There is a version of the model that can be used for companies transitioning from rapid growth to more moderate growth, but the calculations are much more complicated.
Disadvantages of DDM
A major shortcoming of the model is that it works best for a stock that's already paying dividends. Almost two-thirds of publicly-traded companies don't pay a dividend. Instead, these companies retain all of their earnings in order to grow. You can use the DDM for non-dividend paying companies, but you need to make some pretty tenuous assumptions about when they will start paying a dividend – and how much they'll pay.
Another flaw of the dividend discount model (and any model, for that matter) is that it requires numerous assumptions to be made. Investors must guess a company's growth rate as well as the required rate of return. The model is only as good as its inputs. Even a slight miscalculation in any of these inputs can result in dramatically overvaluing or undervaluing a stock.
An odd weakness of the model is that it cannot value a company if that company is growing its dividend faster than the required rate of return. If the dividend is growing faster, the denominator in the dividend discount model becomes a negative value. For example, suppose Stock A pays a $3 dividend, has a 15% growth rate and has a required rate of return of only 10%. According to the dividend discount formula, the value of Stock A = ($3 x 1.15) /(0.10-0.15) = -$69. That's not terribly useful.
Don’t Underestimate Using the Dividend Discount Model
Despite these flaws, the dividend discount model remains a worthwhile analytical tool. It's simple to use and the model's basic premise -- that the value of a stock is equal to the sum of current and future dividend payments -- is sound. The dividend discount model is a good starting point for valuing a stock since the model encourages investors to think about the relationship between risk, returns and growth.
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