The Dividend Discount Model (DDM) states that the intrinsic value of a company is a function of the sum of all the expected dividends, with each payment discounted to the present date.
Considered to be an intrinsic valuation method, the unique assumption specific to the DDM approach is the treatment of dividends as the cash flows of a company.
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The dividend discount model (DDM) is a method used to estimate the intrinsic value of a stock based on the concept that the share price is worth the present value (PV) of the underlying issuer’s expected dividends.
Given the current stock price of the company, the appropriate discount rate (i.e. required rate of return) based on its risk-return profile, and the expected value of the next year’s dividend, the present value (PV) of all future dividends represents the implied intrinsic value.
Under the dividend discount model (DDM), the value per share of a company is equal to the sum of the present value of all expected dividends to be issued to shareholders.
Although a subjective determination, valid claims could be made that the free cash flow calculation is prone to manipulation through misleading adjustments.
Under the strictest criterion, the only real “cash flows” received by shareholders are dividend payments – hence, using dividend payments and the growth of said payments are the primary factors in the DDM approach.
The formula to calculate the implied stock price under the dividend discount model (DDM) is as follows.
Intrinsic Value Per Share = D1 ÷ (ke – g)There are several variations of the dividend discount model (DDM) with the maturity and historical payout of dividends determining which appropriate variation should be used.
As a general rule, the more mature the company and the more predictable the dividend growth rate (i.e. an unchanged policy with a stable track record), the fewer stages the model will be comprised of.
But if dividend issuances have been fluctuating, the model must be broken into separate parts to account for the unstable growth.
Multi-stage dividend discount models tend to be more complicated than the simpler Gordon Growth Model, because, at the bare minimum, the model is broken into 2 separate parts:
In effect, the estimated share price accounts for how companies adjust their dividend payout policies as they mature and reach the later stages of the forecast.
For instance, unlike the Gordon Growth Model – which assumes a fixed perpetual growth rate – the two-stage DDM variation assumes the company’s dividend growth rate will remain constant for some time.
At some point, the growth rate is then decreased as the growth assumption used in the first stage is unsustainable in the long term.
The dividend discount model (DDM) states that a company is worth the sum of the present value (PV) of all its future dividends, whereas the discounted cash flow model (DCF) states that a company is worth the sum of its discounted future free cash flows (FCFs).
While the DDM methodology is relied upon less by equity analysts and many nowadays view it as an outdated approach, there are several similarities between the DDM and DCF valuation methodologies.
Upon completion, the DDM directly calculates the equity value (and implied share price) similar to levered DCFs, whereas unlevered DCFs calculate the enterprise value directly – and would require further adjustments to get to equity value.
Learn More → Dividend Discount Model (DDM) – Source: Damodaran
The projected cash flows in a DDM – the dividends anticipated to be issued – must be discounted back to the date of the valuation to account for the “time value of money”.
The discount rate used must represent the required rate of return (i.e. the minimum hurdle rate) for the group of capital provider(s) who receive or have a claim to the cash flows being discounted.
With that said, the appropriate discount rate to use in the DDM is the cost of equity because dividends come out of a company’s retained earnings balance and only benefit the company’s equity holders.
On the income statement, if you imagine going down from “top-line” revenue to the “bottom-line” net income, payments to lenders in the form of interest expense affect the ending balance.
Net income is thus considered a post-debt, levered metric.
Compared to its more widely used counterpart, the discounted cash flow model, the dividend discount model is used far less often in practice.
To some degree, all forward-looking valuations are flawed – with the DDM being no exception.
In particular, some of the drawbacks to the DDM method are:
The DDM is more suitable for large, mature companies with a consistent track record of paying out dividends. Even then, it can be very challenging to forecast out the growth rate of dividends paid.
In a perfect world where all corporate decisions were made by the book, dividend payout amounts and growth rates would be a direct reflection of the true financial health and expected performance of a company.
But the reality of the situation is that even poorly run companies could continue to issue large dividends, causing potential distortions in valuations.
The decision to issue large dividends could be attributable to:
Commercial banks are well-known for issuing relatively large dividend payouts consistently. The dividend discount model (DDM) is thereby frequently used in such instances.
The multi-stage DDM is most common for bank valuation models, which split up the forecast into three distinct stages:
We’ll now move on to a modeling exercise, which you can access by filling out the form below.
For our DDM modeling example exercise, the following assumptions will be used:
To summarize, the company issued $2.00 in dividends per share (DPS) as of Year 0, which will grow at a rate of 5% across the next five years (Stage 1) before slowing down to 3.0% in the perpetuity phase (Stage 2).
Regarding the company’s risk/return profile, our company’s cost of equity is 6.0% – the minimum return required by equity holders.
Once we have entered the model assumptions, we’ll create a table with the explicit present value (PV) of each dividend in Stage 1.
The formula for discounting each dividend payment consists of dividing the DPS by (1 + Cost of Equity) ^ Period Number.
After repeating the calculation for Year 1 to Year 5, we can add up each value to get $9.72 as the PV of the Stage 1 dividends.
Next, we’ll move to Stage 2 dividends, which we’ll start by calculating the Year 6 dividend and entering the value into the constant growth perpetuity formula.
Upon multiplying the DPS of $2.55 in Year 5 by (1 + 3%), we get $2.63 as the DPS in Year 6. Then, we can divide the $2.63 DPS by (6.0% – 3.0%) to arrive at $87.64 for the terminal value in Stage 2.
But since the valuation is based on the present date, we must discount the terminal value by dividing $87.64 by (1 + 6%)^5.
In the final step, the PV of the Stage 1 phase is added to the PV of the Stage 2 terminal value.
In conclusion, the implied share price derived from our two-stage dividend discount model (DDM) is $75.21.
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