Dividend Discount Model: A Method of Valuing the Price of a Company's Stock

DDM or dividend discount model is a quantitative method to predict the price of company stock. It is based on the theory that the current price of a company’s stock is equal to the sum of all the future dividend payments, discounted to their present value.

The dividend discount model attempts to calculate the fair value of the stock regardless of the market conditions prevailing at the time. It factors in the market’s expected returns and the dividend payout factors. The stock is considered preferable for purchase if the value obtained from the dividend discount model is higher in value in comparison to the current trading price of the shares In such a scenario the stock is considered to be undervalued.

A company producing goods or offering services earns cash flows from its business activities. The profits booked by the company are determined by the cash flows booked by the company, which in turn are reflected in its stock price Organizations also payout dividends to their stockholders, which originate from the company’s profits. The dividend discount model is based on the theory that the value of a company is the summation of the present worth of all its future dividend payments.

The future value of an asset can be calculated with its present value and the interest rate model.

FV= PV *(1+ IR%), for one year

Where,

• FV is the future value of the asset
• PV is its present worth or value
• IR is the interest rate

The equation can also be rearranged as:

PV = FV/ (1+ IR%)

Where all terms have the meaning as explained above.

The dividend discount model is based on this principle. It considers the future value of all cash flows generated by a company and uses it to calculate the Net Present Value using the concept of the time value of money. The Dividend discount model also considers a net interest rate factor, also referred to as the discount rate.

All shareholders investing in stocks are open to the risk of their investments declining in value in the future. They tend to act as moneylenders to companies with an expectation of a rate of compensation or return. For a firm borrowing money from investors, the cost of equity capital represents the market compensation demanded by investors for bearing the associated risk of ownership of the company shares.

‘R’ (r) indicates the rate of return and is estimated using the CAPM or the Capital Asset Pricing Model or the DGM - Dividend Growth Model. The rate of return can only be realized by an investor at the time of sale of shares, it also tends to vary basis investor discretion.

Dividend payout by companies is not based on a certain annual rate, often indicated as ‘g’. The effective discounting rate or discounting factor as mentioned previously for a company’s dividend is indicated as the rate of return minus the dividend growth rate, given as r-g. It represents the effective discounting factor for the dividends of a company.

The growth rate of the dividends can be estimated by the product of the retention ratio and the return on equity (ROE). The retention ratio is the opposite of the dividend payout ratio. As the dividend payouts are sourced from the company’s earnings, they cannot exceed the earnings. The rate of return on the overall stock must be above the rate of growth of the dividends for the future, otherwise, the dividend discount model may lead to negative stock prices.

Dividend Discount Model Formula

The dividend discount model is based on the net discounting factor and the expected dividend paid out per share. Therefore, the formula for the value of the stock can be mathematically represented as

Value of stock = Expected Dividend per share / (Cost of Capital Equity - Dividend Growth Rate)

The value of the stock comes with certain assumptions as it uses variables such as the dividend per share and the net discount rate, which is represented as the required rate of return or the expected rate of dividend growth and the cost of equity.

The dividend discount model is believed to apply only to companies that regularly pay out dividends, as dividends, and the rate of their growth is considered the key input to the dividend discount model.

In scenarios where stocks do not pay out any dividends, the model can still be applied, assuming the value of dividends has otherwise been paid out.

A common and straightforward application of the DDM, dividend discount model is the Gordon Growth Model, which was named after Myron Gordon, an American economist. The model assumes a stable dividend growth rate and calculates the price of the dividend-paying stock using the following mathematical formula:

Price per share for dividend-paying stock = D1 / (r-g)

Where;

• D1 is the estimated value of the dividend for the following year
• r is the cost of equity capital to the company
• g is the constant growth rate for the dividends in perpetuity

Dividend Discount Model Example

Let’s consider a company X which has paid to its investors a dividend of US$1.80 per share in the current year and expects a dividend growth rate (G) of 5% per year till perpetuity. Assuming the cost of equity capital for the company to be 7%, the estimated dividend for next year (D1), the dividend for the current year (D0) adjusted for the growth rate:

D1 = D0* (1+G) = 1.8 * (1+5%) = 1.89 USD

Applying the Gordon growth model, the price per share for Company X will be:

D1/ (r-g) = 1.89/ (7%-5%) = 94.5 USD