Dividend discount model is a quantitative method which is used to value a company’s stock price based on the theory that the current price of a stock equals the total of all of the company’s future dividends when discounted back to their present value.
If the value from the dividend discount model is higher than the current share price, then the stock is undervalued.
The dividend discount model assumes that the intrinsic value of a stock reflects the present value of future cash flows. Dividends are positive cash flows generated by companies to distribute among shareholders.
The dividend discount model provides an easy method for determining the stock price from a mathematical viewpoint. But the model relies on many assumptions that cannot be easily estimated.
The Dividend Discount Model
Companies make profit by selling products or services and use the profits to distribute dividends among shareholders. The dividend discount model uses the time value of money principle. The formula is:
FV = PV*(1+r)
FV = The future value of cash flow
PV = Present value of cash flow
r = The rate of return
The present value from the future value can be calculated by rearranging the formula:
PV = FV/(1+r)
Discount Factor
Shareholders expect a return on their investment because they bear the risk of decline in the value of their purchased stock.
Analysts can determine the discount factor using the dividend growth model or capital asset pricing model. The dividend discount model shows how much the stock should cost for the expected return.
Growth Rate
The growth rate can be calculated as return on equity multiplied by the retention rate. The rate of return of the stock should be greater than the expected dividend growth rate for future cash flows.
Gordon Growth Model
The Gordon Growth Model assumes a stable dividend growth rate and it is the most common version of the dividend discount model. The formula is:
Stock value = Expected dividend/ (Cost of equity-growth rate)
If the formula is used in a mathematical way, then:
PV0 = D1/ (r-g)
Where,
PV0 = Present Value of Stock
D1 = Dividend at the end of the first period
r = Discount rate
g = Expected growth rate
One-period Dividend Model
Analysts use this model to calculate the intrinsic value of stocks to be sold in one year. The formula is:
PV0 = D1/ (1+r) + SP1/ (1+r)
PV0 = The present value of stock
D1 = Dividend at the end of one year
SP1 = Selling price of the stock at the end of one year
r = Discount rate
Multi-period Dividend Model
This model is used when investors expect to hold the stock for multiple periods. The formula is:
PV0 = D1/ (1+r) ^1+D2/ (1+r) ^2+…. +Dn/ (1+r) ^n+SPn/ (1+r) ^n
PV0 = The present value of stock
D1 to Dn = Dividends at the end of each period
SPn = Selling price of the stock at the end of the period
r = Discount rate
The multi-period dividend model is challenging because it is used to forecast the dividend payments for multiple future periods.
Problems with Dividend Discount Model
There are some shortcomings with the dividend discount model. The model assumes a constant growth in perpetuity which is highly unlikely. If the model is applied to small-dividend stocks, it will yield inaccurate results.
The model is most suitable for stable companies and it is not good for start-ups and for those companies who are in the growth stage of development.
It may not be a good model to value new companies because they have fluctuating dividend growth rates or no dividend at all.
When companies have lower rates of return, the model doesn’t work well, and the model fails when a company continues to pay dividends if it incurs loss or fewer profits.
Advantages of the Dividend Discount Model
The model has strong theoretical and mathematical background and it eliminates potential subjectivity. The model is most applicable to those mature companies who regularly pay dividends.
Consistency in dividend payments eliminates risk and from a valuation perspective it is easy to determine the discount rate in that case.
But it can also be applied to those companies who don’t pay dividends by making the assumption that those companies pay dividends. Dividends influence stock prices so the model is of great importance for companies.
How Investors can use the Model?
The dividend discount model helps investors in making comparison between companies and to value shares outside of the current market conditions.
The model indicates underlying investment opportunities and should be used with other techniques and information.
