The Dividend Discount Model Still Going Strong

The following is a guest blog post:

Whenever there is a market turmoil, investors turn to value investing. Value investing allows the choice of undervalued stocks, which actually trade for less than their intrinsic value. In fact, what value investing seeks for is the stocks of companies that the market estimates they have a potential to deliver strong fundamentals so that their stock prices further until reaching their intrinsic value. Normally, undervalued stocks are a good opportunity to buy, especially in a volatile market, because the markets have the tendency to overreact both to good and bad news, thereby resulting in prices that do not correspond to a company’s fundamentals.

 

The Dividend Discount Model

The Dividend Discount Model (DDM) seeks to value a given stock by using projected dividends, which it discounts to their present value. The notion is that, when you buy a stock, the only direct inflow is the expected dividend. Thereby, the dividend discount model uses this as a basis to claim that the value of a stock should be equal to the present value of the expected dividends over time.

 

 

1. Projected Growth

To calculate the projected dividend growth, you should consider the stock’s dividend history. For instance, if a stock declares an annualized dividend of $2.00 per share with an actual dividend growth of 165% over the last 15 years, then the average projected growth is 11% (165%/15). Alternatively, you can use the Gordon Growth Model, which determines the intrinsic value of a stock for a given period of time considering a constant growth rate for the company’s dividends. Some obvious candidates for the Gordon Growth Model are the regulated companies because their growth rates are always correlated to the growth rate of the economy they operate in and they normally pay high dividends. Also, real estate investment trusts (REITs) are good candidates because they pay out 95% of their earnings in dividends and they rarely demonstrate extraordinary growth.

Perhaps the only drawback of the Gordon Growth Model is that it assumes a constant growth rate in dividends, which is an assumption that it is difficult to meet, especially in times of extreme volatility.

 

2. Discount Rate

The formula to calculate the future value of dividends is:

FV = PV x (1+gr)^n

where

FV = Future Value

PV = Present Value

gr = growth rate

n = number of years

Let’s revisit the example above: if a dividend is worth $2.22 15 years from today, how much it is worth today so that you still have $2.22 in 15 years? Assuming a growth of 11% per year, what is the present value of the dividend? Solving the above formula for PV, we get:

PV = FV / (1+gr)^n

Plugging in FV= $2.22, gr=11% and n=15, we get a PV of $0.46.

Here the table below to cross-check the values:

 

Year

Growth

Dividend

Y0

0%

0.46

Y1

11%

0.57

Y2

11%

0.68

Y3

11%

0.79

Y4

11%

0.90

Y5

11%

1.01

Y6

11%

1.12

Y7

11%

1.23

Y8

11%

1.34

Y9

11%

1.45

Y10

11%

1.56

Y11

11%

1.67

Y12

11%

1.78

Y13

11%

1.89

Y14

11%

2.00

Y15

11%

2.11

Y16

0%

2.22

 

The DDM calculates the present value of a stock as follows:

Present Value = Dividend per share / (R discount – R dividend growth)

In the DDM, if the present value of the stock is lower than its market value, then the stock is overvalued, representing an opportunity to sell. Instead, if the present value of the stock is higher than the market value, then the stock is undervalued, representing an opportunity to buy.

 

Can Online Platforms Accommodate You For Value Investing?

Investing in binary options is a great way to capitalize on market volatility and predict the future movement of a stock, a commodity or a currency. In its strictest sense, the only cash flow investors receive when investing in the stock market is the dividend. Online trading platforms like 10trade can offer you the opportunity to capitalize on market volatility without panicking. Through 10trade, you can buy discounted stocks at low prices and reap the returns on your investment in a collected value way. Just make sure to properly select the investments that suit your investor profile. Remember that value investing is not growth-oriented, but it rather focuses on companies whose growth doesn’t necessarily correlate to their fundamental growth.

 

 

Conclusively, the simplest form of valuing equity is the dividend discount model. While many analysts consider it outdated, still it can offer valuable output for a dividend stock as well as drive discounted cash flow valuation. In fact, a dividend discount model is a great tool for estimating value.

13 thoughts on “The Dividend Discount Model Still Going Strong

    • Hi luca,

      I think the author was just trying to illustrate the point of using the dividend discount model as a method for finding value and growth with a particular stock. I do agree with you that an 11% projected growth for all those years seems a bit high. Thank you for stopping by and commenting.

  1. Hi all,

    is this sentence correct? :

    “In the DDM, if the present value of the stock is lower than its market value, then the stock is overvalued, representing an opportunity to sell. Instead, if the present value of the stock is higher than the market value, then the stock is undervalued, representing an opportunity to buy.”

    or maybe i didn’t understand the model.?

    Are you using dividend discount model for value investing ? i understand that is a very simple model but i wonder…why people invest so much time reading finance sheets and research companies for a couple of months before they “value invest” on them ?

    DIVHUT are you usually using this model alone ??

    thanks all and great blog,
    i am invested in Us stocks but i am very interested in investing in International stocks but my problem is understanding if they are undervalued.

    Katon

    • Hi katon,
      I’m not DivHut but i would like to answer to you.

      The sentence is correct. If you have a present value of 30$ with the market that is pricing it at 50$ that means that the market is paying an extra money to buy that stock -> overvalued. You have an opportunity to sell that.
      Author is using the word Market Value, which is essentially correct but i would use the word market price instead.
      DDM is a useful model for investing but you need to address other issues.
      If you have a company which seems to be priced fair (ie market price = DDM price) you should investigate further if there’s any issue in the company. Good companies are not priced at fair value usually. Instead they are priced at a premium that the investor is willing to pay for the stability of the stock and the financial results. KMI was priced fair at 35/36$ at a certain point, but if you didn’t read the balance sheet you never would have seen that the dividend cut was going to take place.
      Plus, remind that DDM is a very subjective model, meaning that a slightly different estimate of k or g (k especially, the required return on capital) might lead to very substantially different results.

      I would like to know if divhut agrees.

      Bye!

      Luca
      luca recently posted…Munich re (Muv2)- Dividend IncreaseMy Profile

    • Hi katon,

      To answer your question I do not use the dividend discount model when deciding my purchases. I primarily look at the dividend history of a particular stock, it’s payout ratio and dividend growth rate first. The I look at basic valuation metrics such a current PE and historical PE. Of course, much depends on stock price within my current portfolio too. In other words, if a stock I own has gone down quite a bit I may add to that position simply to average down in purchase price regardless of current valuation metrics. Hope this answers your question.

    • Hi ARB,

      I can understand where you are coming from. To tell you the truth, I don’t really use the dividend discount model when making my buy decisions for dividend stocks. Even though I don’t use the model it does have its supporters and many swear by the method. Thank you for commenting.

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