There are a number of methods that investors and analysts use to determine the ‘correct’ price of a stock based on the financials of the issuing company and the stock’s performance over time. The use of dividend payments to determine a stock’s intrinsic value is a popular and relatively accurate method, especially when it comes to companies that pay dividends consistently each year. Depending on the stock’s dividend history and predicted future dividend payments, different dividend discount models may be used. The Dividend Discount Model is one such valuation method known for its simplicity.
What Is the Dividend Discount Model?
The Dividend Discount Model is a dividend-based valuation model that relies on a discount formula to estimate the present value of a stock based on assumptions about its future dividend performance. This model can be used to determine the amount an investor can reasonably expect to pay for a stock if it pays consistently increasing dividends each year. If the model yields a present value that is higher than the current price of the stock, then the stock is undervalued and can be considered a smart investment since the returns it is likely to generate in dividends alone exceed the initial capital required to purchase the stock. If this model yields a present value that is substantially lower than the current stock price, it may be overvalued and could fail to generate sufficient returns.
The Dividend Discount Model is very simple and assumes a consistent rate of dividend growth in perpetuity. For this reason, it is best applied to well-established companies that already have a steady track record of increasing dividends.
The Benefits of the Discount Model
One of the key aspects of the Dividend Discount Model is that it uses a discounting method to estimate the present value of a stock. This simply means that the formula takes into account the investor’s required rate of return rather than simply adding up hypothetical dividend payments ad infinitum. The inclusion of the required rate of return, or discount rate, means that the Dividend Discount Model yields the present value of a stock based on what an individual investor wants to gain.
The Gordon Growth Model Formula
Popularized by Professor Myron Gordon, the Gordon Growth Model is deceptively simple. All that is required to determine the present value of a stock is the dividend payment one year from the current date, the expected rate of dividend growth and the required rate of return, or discount rate. It bears repeating, however, that this model is based on the assumption that dividends will continue to grow at a constant rate forever, so it is not applicable to stocks with volatile dividend yields.
Stock Value = D1/r-G
In this equation, D1 is the expected dividend payment one year from the current date, r is the required rate of return and G is the dividend growth rate expected to continue in perpetuity.
Like most mathematical concepts, the easiest way to master the Dividend Discount Model is to see it in action, step-by-step. As mentioned above, this model works best with well-established companies that have consistent dividend histories. Procter & Gamble (PG ), the well-known health, beauty and home goods conglomerate, provides the dividend history for this example.
Procter & Gamble has paid consistent quarterly dividends since 1993. In the four years between 2011 and 2014, the company paid total dividends of $2.104, $2.248, $2.406, $2.574, respectively, reflecting an increase of about 7% per year. An investor looking at P&G as a potential investment in early 2014 might reasonably have assumed that this trend would continue and could use the Dividend Discount Model to determine whether or not the stock was well-priced based on its future dividend payments.
Each investor’s required rate of return is different. For the purposes of this example, however, a 10% discount rate is used, which represents a healthy return without being overly ambitious.
The first step in calculating the present value of P&G stock in 2014 is to calculate the 2015 dividend payment based on the most recent 2014 payment and its expected 7% growth.
D1 = $2.574 * 1.07 = $2.754
Next, the discount rate, dividend payment, and dividend growth rate are input into the Dividend Discount Model to yield the present value of P&G stock in 2015 based on its anticipated dividend payments.
Stock Value = $2.754 / (0.1 – 0.07)
= $2.754 / (0.03)
Based on this valuation method, an investor that was looking for a 10% rate of return in late 2014 should have purchased P&G stock if it was priced at $91.81 per share or lower. In reality, P&G was priced at just over $92 at the end of 2014 and hovered near $90 per share in early 2015, so the Dividend Discount Model provided a solid guideline for this stock’s valuation. However, dividends paid in 2015 did not live up to the 7% growth rate, instead increasing only 3% over the prior year. Not surprisingly, this deceleration coincided with a drop in the stock’s value, which has declined steadily throughout the year to settle in the low $70s as of October 2015.
Benefits and Drawbacks
The Dividend Discount Model, like any valuation method, has both advantages and disadvantages. Though it is undoubtedly useful for evaluating stable companies with steady dividend histories, it does not provide accurate estimates for companies whose dividend payments are sporadic or do not increase at a consistent rate. In situations where projected dividend payments are not so simple, a more complex dividend-based valuation method may be better suited, especially for companies who are growing rapidly, are experiencing financial troubles, or are in decline.
Another huge benefit of the Model is its simplicity. Because it requires minimal information and can be calculated very quickly, investors and analysts like to use this model as a benchmark or guideline. However, the simplicity of the model is the result of the fact that it takes unpredictable market activity and company-specific factors, such as product innovation, public sentiment and growth potential, out of the equation entirely. Like many predictive formulas, the Dividend Discount Model is based on very broad assumptions about an unknowable future, so it should not be used as a stand alone method of stock analysis.
The Dividend Discount Model is the basis for a number of more complex dividend-based stock valuation techniques that will be discussed in future articles. While the formula’s inherent simplicity narrows its applicability, a firm grasp of the mechanics of this model and the purpose behind its creation are necessary in order to fully understand and implement its more evolved derivatives.
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