Dividend Discount Model is a valuation formula used to find the fair value of a dividend stock. In other words, it is used to evaluate stocks based on the net present value of future dividends.
Dividend discount model is often referred to by 3 other names:
1.Dividend Growth Model
2.Gordon Growth Model
3.Divident Valuation Model
The elegance of the dividend discount model is its simplicity. The dividend discount model requires only 3 inputs to find the fair value of a dividend paying stock.
Dividend Discount Model Formula The Gordon Growth Model is one of the most commonly used variations of the dividend discount model. The model is called after American economist Myron J Gordon who proposed the variation. The GGM is based on the assumptions that the stream of future dividends will grow at some constant rate in future for an infinite time.
The dividend discount model tells us how much we should pay for a stock for a given required rate of return.
Example:
Imagine a business were to pay $1.00 in dividends per year, forever. How much would you pay for this business if you wanted to make 10% return on your investment every year?
10% is your discount rate. The fair value of this business according to the dividend discount model is $10 ($1 divided by 10%).
Solution:
We can see this is accurate. A $10 investment that pays $1 every year creates a return of 10% a year – exactly what you required.
One-period Dividend Discount Model
The one-period discount dividend model is used much less frequently than the Gordon Growth model. The former is applied when an investor wants to determine the intrinsic price of a stock that he or she will sell in one period from now. The one-period dividend discount model uses the following equation:
Multi-period Dividend Discount Model The multi-period dividend discount model is an extension of the one-period dividend discount model wherein an investor expects to hold a stock for the multiple periods. The main challenge of the multi-period model variation is that forecasting dividend payments for different periods is required. The model’s mathematical formula is below:
The capital asset pricing model shows the inverse relationship between risk and return. The required return for any given stock according to the CAPM is calculated with the formula below:
All that is left to calculate the required return on any stock using the CAPM is beta. Beta has a significant effect on the required returns of different stocks
The Importance of The Dividend Growth Rate
The dividend growth rate is critically important in determining the fair value of a stock with the dividend discount model.
The denominator of the dividend discount model is discount rate minus growth rate. The growth rate must be less than the discount rate for the dividend discount model to function. If the growth rate estimate is greater than the discount rate the dividend discount model will return a negative value.
There are no stocks worth any negative value. The lowest value a stock can have is $0 (bankruptcy with no sellable assets).
The growth rate in dividends can be estimated in a number of ways:
Using the company’s historical average growth rate
The dividend discount model has serious flaws; but so does every other valuation metric. Investing is an art, not a science. There is no one perfect way to invest.
The dividend discount model is a useful tool to gauge assumptions about a dividend stock. It is not the final word on valuation, but it does provide a different way to look at and value dividend stocks.
