What is Dividend Discount Model (DDM) and How to Use the Formula
Investors and traders use the dividend discount model, which is a quantitative tool to ascertain the price of a stock. It uses future discounted dividend payouts to predict stock prices. It functions on the assumption that the fair value of any stock is equal to the sum of all future dividend payouts discounted to its current value.
This blog provides complete detail about the dividend discount model, how it predicts the price of stocks, its benefits, formula, examples, types and more. Read on!
What Does Dividend Discount Model (DDM) Indicate?
If the dividend discount model for a particular stock depicts a higher value than its prevailing market price, it indicates that the stock is undervalued. Therefore, you can go ahead with buying them as it may give handsome returns in the future.
On the other hand, a DDM value lower than the current price of stocks indicates that said stock is overvalued. It is also a sign that you should sell these stocks as they may correct sharply in the future.
How Does the Dividend Discounting Model Work?
This model is heavily reliant on several assumptions. It is a mathematical value of a stock based on cumulative future dividend payments discounted to its current value. You will require future dividend payouts, cost incurred on equity capital, and growth rate of dividends for the successful functioning of this model.
An intrinsic value of a stock is the net present value of the sum of all future cash flows that a company will generate. As dividends are positive cash flows that a company generates and distributes among its shareholders, we can take this into account while predicting the future value of a stock.
The dividend growth model focuses on the time value of money while determining the fair value of a stock. It has two major components, namely, the expected market returns and cumulative future dividend payments in discounted form.
Dividend Discount Model Formula
Here is the dividend discount model formula, which will help us better understand the concept:
Dividend Discount Model = Intrinsic Value of a stock = Current sale value of stock + Sum of the present value of dividends.
In case a company or stock does not pay any dividend, future cash flows will be equal to the stock’s sale price.
Another popular formula of the dividend discount model is the Gordon growth formula. It is as follows:
Price of a stock = D/ (r-g);
Here, D represents future dividends that a company may pay;
r is the cost associated with acquiring equity capital, and
g represents the growth rate of future dividend payments.
As seen from the above formulae, this model is beneficial for ascertaining the value of stocks of those companies which have a stable and consistent dividend scenario. Another thing that you must keep in mind while using this model is that the discounting factor plays a huge role when it comes to calculating the expected returns. A low discount rate will translate into lower returns and vice versa.
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Example of Dividend Discount Model
Here is an example of the dividend discount model:
First, let’s consider a company that is currently not in its growth phase. In this scenario, we will use the zero growth model. Let’s say that the company is paying dividends amounting to Rs.75 per annum. Moreover, the required growth rate of stock is 10%.
In this scenario, you can compute the intrinsic value of a stock by following this formula:
Intrinsic value = Yearly Dividend/ Required rate of return
= 75/0.1
= 750
Let’s consider another example of the dividend discount model, which focuses on the steady growth rate of dividends. Suppose a company is paying Rs. 50 per year, and the steady growth rate of dividends is 8%. Additionally, the expected rate of return from these stocks is 12%.
In this case, intrinsic value of stock = Divided (1+g)/(r-g)
= 50 (1+0.08)/ (0.12-0.08)
= 50 *27
= 1350.
Types of Dividend Discount Model
The different types of DDMs are as follows:
1. Zero Growth Dividend Discount Model
It assumes a uniform or a constant dividend payment. It means that the value of the dividend of a particular stock will remain the same forever, or there will be no increase or decrease in dividends.
Under this scenario, the intrinsic value of a stock will be equal to annual dividend payouts divided by the expected rate of return. However, one must note that the price of a stock may change if the expected rate of return changes. This may happen due to changes in the market situation.
2. Constant Growth Dividend Discount Model
As the name suggests, this model assumes a uniform yearly increase in dividends. They do not change and remain constant throughout their time period. It is also referred to as Gordon’s growth model.
Dividend payouts under this model increase at a specific rate every year. This type of trend is more common in established companies that witness a steady rise in dividends. The formula for this model is as follows:
Value of stock = D0 (1+g)/(Ke-g) = D1/(Ke-g);
Here, D0 is dividend payments in the current year;
D1 is dividends received the next year;
Ke represents the discount rate; and
g is the dividend’s growth rate.
3. Variable Growth Rate Dividend Discount Model
This dividend model assumes a variable or different growth rate of dividends every year. There can be various trajectories formed by dividends; however, the most common form of trajectories are as follows:
A high rate of growth in dividends, a slower growth rate, and finally, transitioning to a stable rate of growth. You must add the present value of each stage to ascertain the intrinsic price of a stock. There are two substages of this growth model, which are as follows:
1. Two-stage Dividend Discount Model
Under this, dividends will see a two-phase trend or trajectory. Initially, it will witness a very high rate of growth followed by a stable rate of growth. This is more common among companies paying dividends in cash.
2. Three-stage Dividend Discount Model
As the name suggests, this model will witness three variable phases of dividend growth. First, it will witness a very high growth rate, followed by a slower growth rate and finally, stabilising at a steady growth rate. It is common in matured and established conglomerates.
Advantages of the Dividend Discount Model
Here are some advantages of using the dividend discount model:
1. Consistency
It is a reliable and trusted model for predicting the intrinsic value of stocks. Companies pay dividends in cash to most of their shareholders. Any tampering with the same may affect their fundamentals. Therefore, the variables used in this are robust.
2. Sound Logic
The DDM functions or revolves around the time value of money depending on future cash flows. This principle is tested and will give accurate results.
3. Established Businesses
This model considers regular dividend payments made to stakeholders. It indicates signs of an established or matured business and helps investors make an informed decision.
What Are Some Problems of DDM?
Some limitations or disadvantages of this model are as follows:
1. Sensitive
Even a small change in the growth rate of dividends or expected returns may lead to drastic changes in the final intrinsic value of stocks. It breeds volatility which may be detrimental to investors.
2. Irrational Assumption
This model assumes that companies will pay a uniform rate of dividends to investors every year. This is an irrational assumption as companies give dividends out of profits which are dynamic and not uniform.
How Do Investors Use Dividend Discount Model?
This model is very useful in estimating the intrinsic value of a stock. Investors will get to know the expected future price of a stock by discounting future cash flows such as dividends. They can use it for making investment decisions, i.e., whether to buy, sell or hold stocks based on their expected returns.
However, investors must be cautious and avoid using this model for all scenarios. This is because high-priced stocks might not pay regular dividends; hence, investors can use DDM for realising the price growth potential only.
Final Word
The Dividend Discount Model is a useful quantitative tool that helps investors in finding out the intrinsic value of a stock after considering discounted cumulative future dividends. However, this model comes with some serious assumptions that analysts must fulfil before putting this into action.
FAQs
Ans: In case the dividend discount model is lower than the selling or trading price of a stock, it indicates the overvaluation of the stock. This is also a signal that you should sell and exit this stock as it may incur significant losses.
Ans: Dividends are payments made to shareholders at fixed time periods. Moreover, it is a part of the stock price. A company paying dividends will have a higher stock price than a company not paying one.
Ans: Like DDM, the capital asset pricing model values or measures investments. It calculates the returns and risks associated with an investment depending on market average.
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