The dividend discount model is a method used to predict the value of a company’s stock price. The DDM can help them gauge the intrinsic value of a stock, or the value they think the stock should be trading at, to see whether it is undervalued or overvalued. It’s a model for investors who are interested in buying dividend stocks.
The valuation is based on the assumption that the sum total of all the company’s future dividends discounted back to their current value can determine the intrinsic value of a stock.
While this model has been around for some time, there are many variations of the model and it can get complicated fast. That’s because to use the model, several assumptions have to be made, which you’ll learn more about below.
Understanding Dividend Discount Models
A company’s stock price is influenced by many factors but a primary one is how much profit it earns. Companies that distribute dividend stocks give shareholders what are called dividend payments from the profit they earn. Dividend discount models are based on the idea that the sum total of all a company’s future dividend payments can determine the present value of a company. The goal here is for investors to see what their potential returns could be if they invest in a stock.
DDM formulas also factor in the time value of money – the idea that money will be worth less in the future than it is now. Based on this concept, companies that pay robust dividends today are sometimes said to be worth more than ones that delay dividends to the future.
The challenge with dividend discount models is they rely on assumptions about future dividend payments, how the dividend payments will grow, and the cost of equity capital.
DDM Formulas
As mentioned earlier, there are multiple variations of the DDM. One of the most widely used is the Gordon Growth Model, established by American economist Myron J. Gordon. The primary goal of this model is to help investors reach a stock’s intrinsic value, or the price investors believe the stock should be trading at, based on the dividends potential constant rate growth. This can be a simple model to use as it assumes that future dividends will grow at the same constant rate in the indefinite future.
The Gordon Growth Model is ideal to apply to stable businesses with a history of steady cash flow and dividend growth. It may also be helpful for investors looking to buy a stock and hold it for a long period.
The formula for this DDM model is:
P = D1/r-g
P = stock price
D1= dividend payment on period from present
r = estimated cost of equity capital
g = constant growth rate
Other DDM models investors can use include the on period dividend discount model, which can be used to determine the intrinsic price of a stock they hope to sell in one year. There’s also the multi-period dividend discount model, which can tell an investor the intrinsic price of a stock they plan to hold for multiple periods. This model allows you to use varying dividend growth rates over the desired period.
A DDM calculation shows a stock’s intrinsic value. When a DDM calculation shows a number higher than what a share is currently trading for, it could imply that the stock is undervalued. When accurate, undervalued stocks can be a goldmine for investors as they can buy shares at a discount. If the price does eventually increase, investors could see generous returns. On the flip side, if a stock happens to be overvalued, an investor may choose to opt out of buying or short sell the stock.
Downsides of DDM
Dividend discount models, for the most part, assume a company will experience stable growth. This isn’t always the case. That said, slight changes to any of the variables in a formula can throw off the valuation of a stock. This is important seeing as the calculations can drive investment decisions.
DDM models may not be ideal when evaluating companies without a steady history of dividend payments or at risk of not paying their dividends. Investors who use this model on said companies could end up with unreliable calculations in terms of stock prices. Even when using a DDM, risk is involved. If unsure whether to invest in a stock, consider speaking to a financial advisor.
