Dividend Discount Model
Dividend discount model (DDM) is a stock valuation tool in which the intrinsic value of a stock is estimated by discounting dividends per share expected in future.
Discount discount model is based on the two basic principles of finance: first, intrinsic value of an investment depends on the future net cash flows it generates; and second, a dollar received today is better than a dollar received after one year (i.e. the concept of time value of money).
People invest in a stock hoping to receive a return, which comes the form of capital gains and dividends. Dividend discount model theorizes that the fair price of a stock should equal the present value of all the future dividends the stock is expected to pay (till eternity). Since even the capital gains reflect an expectation of increased dividend due to increased profitability and growth of the company, estimating intrinsic value based on dividend expectations is relevant in many scenarios.
There are different forms of dividend growth model: the constant growth dividend discount model (i.e. the Gordon growth model) & multi-stage dividend discount model. The most basic model assumes that the dividend per share grows at a constant rate. Other versions project dividend per share more precisely for near future (say 4 periods) and applies the basic version to estimate the terminal value of the stock (say at the end of 4th year) which is discounted back again to time zero.
The stable growth dividend discount model assumes that the dividend grows at a constant rate forever. Though this assumption is not very sound for all companies, it simplifies the process of discounting future dividend cash flows. The formula for present value of perpetuity can be used to find intrinsic value:
|Intrinsic value =||D1|
|r – g|
D1 is dividend per share expected to be received at the end of first year. It may be estimated based on current dividend per share projected for 1 year at the prevailing dividend growth rate (i.e. D1 = D * (1 + g)).
r is the required return on the stock (i.e. cost of equity)
g is the expected dividend growth rate
Gordon growth model (i.e. stable growth model): Estimate the intrinsic value of a stock which is currently trading at $35 based on the following data:
- Required rate of return (i.e. cost of equity) is 10%.
- Current dividend per share is $2.
- Dividend growth rate forever is 5%.
Is the stock a good investment or not?
Dividend per share at the end of Year 1 = Current dividend per share * (1 + growth rate) = $2 * (1+5%) = $2.1
Intrinsic value = $2.1/(10% - 5%) = $2.1/5% = $42
Since the intrinsic value ($42) of the stock is higher than its current price ($35), it is expected to generate positive return and hence it is a good investment.
Gordon growth model should be used to value stocks of companies in matures industries, which have stable capital structure (i.e. proportion of debt and equity), stable earnings and dividend payout ratios. It is not very useful for high-growth companies in fast-paced industries because its assumption of constant moderate growth does not apply there.
Written by Obaidullah Jan, ACA, CFA <--- Hire me on Upwork