What is the purpose of the Dividend Discount Model (DDM)?
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The dividend discount model is used to estimate the intrinsic or fair value of a stock.
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The dividend discount model is a popular method for valuing stocks. It relies on a few parameters, like the expected dividend of a company, cost of equity, and expected growth rate in dividends. It is a simple model to use. That’s why several analysts use it. However, it has many limitations. For example, it assumes that a company will pay dividends, which may not happen because companies are not legally obligated to pay dividends. Read this blog, as it explains this model in detail, its types, how to use it, and its advantages and limitations.
The dividend discount model is a method to find the fair value of a stock. As per this model, a stock’s fair value is the present value of all the dividends an investor is likely to receive from it in the future.
For this model, you need to first estimate the dividends you are likely to receive from a company in the future. Then, you need to find the cost of equity or the expected return from investing in this stock. You also have to find the estimated growth rate in dividends. This is a reasonably simple way to arrive at the fair or intrinsic value of a stock, as it requires a few inputs.
Typically, investors estimate a company’s dividend growth by analysing how its dividend payouts have grown in the past. Then, they need to estimate the discount rate or cost of equity. For this, they check what kind of return they expect by investing in a stock from this industry.
By doing so, they arrive at a stock’s intrinsic value in a simple manner.
To use this model, you need to do two things. First, you need to estimate how much dividend you are likely to receive from a company till perpetuity and at what rate the dividend payout is likely to grow. Second, you need to estimate the cost of equity.
Estimating dividends will require you to make certain assumptions. Let’s say that a company paid Rs. 5 per share dividend last year. You also noticed that its dividends have grown at around 2% per year in the last 10 years.
Moreover, its cash flows are growing in a consistent manner. After all, a company pays dividends from its cash flows. Hence, it can be safe to assume that its dividends will continue to grow at 2% per year from this year onwards.
While estimating dividends, you should check how a company’s cash flows have grown in recent times. Besides, you must also understand the thought process of its management. For example, if the management is not finding avenues for investment, it may pay more dividends to its shareholders.
Now, let’s talk about the discount rate. When people invest in a company, they expect a return. That return is usually estimated by using the capital assets pricing model. From this return, we need to deduct the estimated rate of growth in dividends and the result is the discounting factor.
There are three types of dividend discount models:
Gordon Growth Model: This model assumes that future dividends from a company will grow at a constant rate for an infinite period of time. Typically, this model is used for stable businesses with significant cash flows and a relatively constant rate of growth in dividends. Usually, such companies have a stable business model, which allows them to grow their dividend payouts at a constant rate.
One-Period Dividend Discount Model: This model is used when an investor wants to find the fair value of a stock which he intends to sell in one period, which is typically one year. As the investor wants to hold the stock for a short period, he can expect only one dividend payment. Since he wants to sell it after a year, he will also receive the selling price of this stock. Now, to find the intrinsic value, you need to add that one dividend payment to the estimated selling price of the stock and discount it to find its present value.
Multi-Period Dividend Discount Model: If you extend the one-period dividend discount model, you'll arrive at the multi-period dividend discount model. In this model, an investor intends to hold a share for many periods. For this, you need to estimate dividends for different periods. The expected future cash flows are several dividend payments and the estimated price at which you will sell the stock. To arrive at the fair value of the stock, you should discount these cash flows to arrive at their present value.
There are a few advantages of using this model:
Ease of calculation: This is a mathematical model; however, it’s not difficult to use. The calculations involved are fairly basic. Hence, a significant number of analysts can use it.
Only a few inputs are required: As opposed to many methods to arrive at the fair value of a stock, in the dividend discount model, you need only a few inputs. You only need to estimate the dividends of a company, which should be fairly easy if it’s a stable company. Then, you need to estimate a discount rate, which shouldn’t be too difficult, either.
Dividend Discount Model (DDM) Formula
The formula for the dividend discount model is provided as follows:
Value of a Share = (Expected Dividend Per Share at the end of Year 1)/(Cost of Equity minus Growth Rate in Dividends).
So, if you want to use the DDM, you need to estimate three variables mentioned in the formula above, which are dividends expected from a share at the end of the first year, cost of equity, and rate of growth in dividends.
Limitations and Criticisms
This model assumes that a company’s dividend payouts will grow at a stable rate, which rarely ever happens. Besides, a stable growth rate in dividends is possible only for stable companies. Many companies, which are in a growth phase, have to invest considerable amounts to expand. Such companies may not have sufficient cash flows to pay dividends. Hence, the dividend discount model is difficult to use for such companies.
This model is extremely sensitive to changes in its inputs. It has only three inputs. Even if we change the value of these inputs marginally, the result value changes dramatically. Therefore, it often becomes difficult to arrive at a realistic intrinsic value using this model.
This model assumes that a company will actually pay dividends. As per the law, companies are not under any obligation to pay dividends. Hence, using dividends to estimate the fair value of a stock may not be the best approach.
Let’s understand this model with an example. Suppose a company has paid a dividend of Rs. 10 per share this year. You have analysed how its dividends have grown over the past 10 years. Based on that, you expect its dividends to grow at 3% per year in perpetuity. Let’s say its cost of equity is 10%. To find the dividend at the end of year 1, you should follow the equation below.
Dividend at the end of Year 1 = 10 X (1+3%) = 10.3
Price Per Share = (Expected Dividend Per Share at the end of Year 1)/(Cost of Equity minus Growth Rate in Dividends) = 10.3/(10% - 3%) = Rs. 147.
Now that you have learnt what the dividend discount model is, you will feel inclined to use it. Bear in mind that it has its advantages and limitations. Before using it, you must check whether a company has a track record of stable growth in dividends. If that’s not the case, you are better off using other methods to estimate the fair price of a stock. Even when you find a company suitable to use this model, don’t take the decision to buy or sell it based on only this model. Investors are advised to use multiple methods to arrive at the fair value of a stock and based on that they should make their decisions.
Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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The dividend discount model is used to estimate the intrinsic or fair value of a stock.
The key components are: expected dividend from a stock at the end of the first year, cost of equity, and growth rate in dividends.
The formula for this model is as follows:
Value of a Share = (Expected Dividend Per Share at the end of Year 1)/(Cost of Equity minus Growth Rate in Dividends).
Different variations of this model are: Gordon Growth Model, One-Period Dividend Discount Model, and Multi-Period Dividend Discount Model.
This model assumes that a company will pay dividends, which may or may not happen. Then, it assumes that its dividend payouts will grow at a stable rate, which doesn’t happen in the case of most companies.
If as per this model, the fair value of a stock is higher than its stock price in the market, then you can buy the stock, and vice versa. That said, you should consider multiple factors to decide whether to buy or sell a stock and not depend entirely on one model.
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