What Is the Dividend Discount Model?
If you’re looking to determine how much a given stock is worth, then there are many stock valuation methods that can be used to do just that. In this article, we'll focus in on one of the older but still commonly used stock valuation methods known as the Dividend Discount Model (DDM).
The DDM says that a given stock’s price today can be determined by the stock’s current and future dividend payouts. To understand how this works, let’s start off with the no-growth scenario and then introduce growth from there.
DDM Without Growth
Most companies strive for continual growth. That said, continual growth is not always possible if the market for the given company’s goods and services is relatively static and the company has already captured most of it or is unable to capture more. This is where the DDM with no growth formula comes into play.
The formula without growth is: P = D / R
- P = Stock’s price
- D = Dividend payout amount
- R = Necessary return rate
As an example, say that a company, company A, has a current dividend payout of $5.00 per share and it can reasonably be expected that it will continue to pay out this $5.00 dividend for the foreseeable future. This means that from the formula above, the dividend payout amount, D, = $5.00.
While it’s generally not too difficult to determine D, the necessary return rate, R, is a bit more complicated and subjective as there are many ways to determine this value. For example, you could say that the current market average is 10% and company A is slightly riskier than the overall market. Factoring in the risk, you decide that a return rate of a few percentages higher than the current market average is warranted and require a return rate of 13%.
Or, you many look at company A’s current bond rate and expect a few percentages higher since a company’s stock is generally riskier than its bonds. For example, if company A’s bonds have a coupon rate of 5%, you may require 8% for its dividends to compensate for that additional risk.
Let’s say that we decide that the dividend return rate we require is 8%. Our calculation would be,
$5.00 / .08 = $62.50.
If the stock’s current price was anything over $62.50 per share, then we’d consider it overvalued. Anything less than $62.50 and we’d consider it undervalued.
DDM With Growth
If a company is expected to grow for the foreseeable future, then the formula needs to be adjusted to incorporate this growth.
The formula with growth is: P = D / R – G
- P = Stock’s price
- D = Dividend payout amount
- R = Necessary return rate
- G = Growth rate
Going back to company A, let’s say that we expect the company to grow by 2% for the foreseeable future. As we determined previously, company A’s dividend payout is $5.00
and the required rate of return is 8%. Adding this growth rate to the formula, we get:
$5.00 / .08 - .02 = $83.33.
Again, the stock price would be considered overvalued if over $83.33 and undervalued if less.
There are a few important items to point out with this formula. First, if the growth rate is greater than the rate of return, then the formula won’t work as the results would end up in the negative.
Second, as the rate of return minus the growth rate approaches 0, the value of the calculation will become less and less accurate. If the decimal difference is less than 0.02, then use additional caution.
Another important item to note is growth in general. Growth is complicated to determine accurately; even the experts often struggle to get it right. You may want to compare different variations of growth and non-growth scenarios.
For example, it may reasonably be expected that a company will grow by 3% annually for the foreseeable future. But there’s a small possibility that number could drop to 1% if certain market conditions change. Depending on your appetite for risk, you may decide that you’re only willing to consider growth at that 1% rate, are still ok at 3%, or maybe you’re somewhere in-between with 2%.
DDM and Variable Earnings Growth
You may have noticed that the DDM with growth formula expects a constant rate of growth. In the real world though, a constant rate of growth is not all that realistic as growth rates tend to be variable with most companies. Does this mean that the DDM with growth is essentially useless?
Not quite. Many companies with variable growth will still work to continually increase the dividend payout over time. For example, a company may endeavor to main a growth rate of 3% on their dividend payout. In some periods, this may mean that more of the earnings will need to go to dividends then others. Still, the 3% rate will be maintained.
Or, a company may average out to 3% growth over the long run. For example, the growth rate is 2% for two years and 5% the year after averaging out to 3%.
This means that the although the DDM won’t necessarily match up completely to reality, it can still work reasonably well in these variable earnings growth scenarios.
DDM and Earnings Decline
In the previous section, we discussed variable earnings growth. But what if the variable earnings trends continually downward rather than upwards? This is one of the more problematic pieces of the DDM as it doesn’t necessarily take this into account. Or, more accurately, it can be easy to overlook this pattern when using the DDM if not also taking into account the company’s overall financials.
For example, say that company A currently pays out 10% of its earnings to its dividend payout, which comes out to $3.00 a share. The next year, company A earns a bit less and needs to payout 12% of its earnings to keep the $3.00 a share payout. Over the next number of years this pattern continues, but the company continues to keep the same dividend payout. In the end, the company files for bankruptcy and the stock becomes nearly worthless.
If an investor using the DDM didn’t check into the company’s financials and recognize this pattern of lower and lower earnings, then that investor may incorrectly value the share price using the DDM with the historical dividend payouts. A similar scenario could also occur with newer less established companies, which are much more difficult to predict in the context of financial stability and consistent dividend payouts.
The main point to emphasize here is that the DDM has a much better chance of being accurate when used against mature companies that have a long track record of financial stability and dividend payouts. Investors shouldn’t rely on the DDM solely for stock valuation.
Other DDM Potential Issues
Other issues with the DDM include:
- Not all companies pay out dividends meaning that the DDM can’t be used universally. This can make stock comparison more challenging than some other potential stock valuation methods.
- The DDM is very sensitive to the growth rate provided and does not work when the growth rate is greater than the required rate of return.
- The DDM becomes more and more inaccurate as the difference between the required rate of return and growth rate approaches 0.
- The DDM generally only works for mature, stable companies with a track record of consistent dividend payouts.
Some pros of the DDM include:
- The core of the DDM is relatively intuitive.
- The DDM can accurately help to compare mature companies with a track record of consistent dividend payouts.
- The DDM formula allows for good deal of input flexibility. Specifically, the required rate of return, growth rate, and even the dividend payout amount can be modified according to a variety of different scenarios helping the investor to predict stock value under a number of conditions.
- DDM is still a common and well understood method of stock valuation used by many in the investment world.
The DDM a method of stock analysis that attempts to value a stock based on its current and future dividend payouts. Although not appropriate in all scenarios, it is still a valuable tool that investors can add to their toolbox.