Equity Investments - The Dividend Discount Model (DDM)

Value of a Preferred Stock
Unlike common equity, preferred stocks pay a fixed dividend. As such, the value of a preferred stock can be calculated using the dividend discount model. The value of the preferred stock is essentially the present value of the dividend in perpetuity, where k is the required return.

Formula 13.1

Value of preferred stock

Example: Calculating the value of a preferred stock
Assume that Newco's preferred stock pays out to an investor an annual dividend of $8 per share. Given a rate of return of 10%, what is the value of Newco's preferred stock?

Value of Newco's preferred stock = ($8/0.10) = $80

Value of a Common Stock
Much like a preferred stock, holders of common stock can also receive dividends. However, dividends on common stock are not guaranteed, nor are they a fixed amount from year-to-year. As such, we can value common stock using dividends over various time horizons.

1. One-year Holding period
Consider a one-year holding period, in this time frame, an investor will receive a dividend and the price of the common stock at the end of the one year, both discounted back by the rate of return on the common equity.

Keeping this in mind, we can calculate the value of the common stock as follows:

Formula 13.2

Common Stock = Dividend + Price at the end of the year
(1+k)1 (1+k)1

Example: Calculate the value of a stock with a 1-year holding period
Newco expects to pay its shareholders common equity, $0.25 per share this year. The investor anticipates Newco's stock will close the year at $30 per share. Given a rate of return of 10%, what is the value of Newco's common stock?

Value of Newco's common stock = $0.25 + $30 = $27.50 per share
(1.10) (1.10)

2. Multiple-year holding period
Given investors can hold a common stock for over a year, it is useful to value a stock over the investor's expected holding period. In this case, the DDM model can be used.

Formula 13.3

Value of common equity

Example: Calculate the value of a stock with a multiple-year holdingperiod
An investor plans to hold Newco's stock for 2 years. Newco expects to pay its shareholders common equity, $0.25 per share over the next two years. The investor anticipates Newco's stock will close the end of that time period at $40 per share. Given a rate of return of 10%, what is the value of Newco's common stock at the end of the two-year time period?

Value of Newco's common stock = $0.25 + $0.25 + $40 = $33.49
(1.10)1 (1.10)2 (1.10)2

3. Infinite Period DDM
To value a common stock using the infinite period DDM, the calculation is simplified much like it is when valuing a preferred stock with infinite dividends.

Formula 13.4

Where k = rate of return, g = growth rate

Example: Calculate the value of common stock with infinite dividends
Newco paid a $0.25 annual dividend in 2004 and expects to pay $0.265 in 2005. Assuming a 6% growth rate and a required rate of return of 10%, calculate the value of Newco's stock.

Value of Newco's common stock = $0.265 = $6.63
(0.10 - 0.06)

Valuing the Common Stock of Companies with Supernormal Growth
When valuing a common stock of a company which is experiencing significant growth, we take a similar approach to valuing the common stock with a multi-year holding period. The difference in the approaches is related to the dividend. A multi-year holding period approach assumes a stable dividend, whereas the dividend changes given the supernormal growth in this approach.

Formula 13.5

Example: Calculate the value of common stock with temporary supernormal growth
An investor plans to hold Newco's stock for 3 years. In that time period, Newco plans to grow at a rate of 6% in the first two years and 3% thereafter. Newco's last dividend was $0.25. Given a rate of return of 10%, what is the value of Newco's common stock at the end of the three-year time period?

To begin, the dividend in each time period must be calculated [D = D0(1+g)]

D1 = (0.25)(1.06) = 0.265
D2 = (0.265)(1.06) = 0.281
D3 = (0.281)(1.03) = 0.289

Since we expect the dividend to grow indefinitely in year 3 and on, the present value of the stock price in year 3 is calculated as follows:

P3 = 0.289 = 4.133

The value of Newco's common stock is as follows:

Newco'scs = $0.265 + $0.281 + 0.289 + $4.133 = $3.80
(1.10)1 (1.10)2 (1.10)3 (1.10)3

Using the DDM to Develop an Earnings Multiplier Model
Developing the earnings multiplier using the DDM begins with the basic determinant of price. Recall, to determine the price of a stock using the DDM, the infinite dividend is divided by the required return minus the growth rate as follows:

To determine the price to earnings multiple, the price of the stock is simply divided by the earnings per share of the stock as follows:

Formula 13.6

Example: Determining a company's price-to-earnings ratio using the DDM
With Newco's $0.25 dividend payout, an EPS of $1.00, calculate the stock's P/E ratio assuming 10% required return and 5% growth.

P/E ratio = 0.25/1.00 = 5%

Look Out!

In terms of changes in the dividend, the required return and the growth rate affect the DDM. Changes in these variables will also affect the stock's P/E ratio.

DDM and the Earnings Multiplier

Related Articles
  1. Fundamental Analysis

    Valuation Of A Preferred Stock

    Determining the value of a preferred stock is important for your portfolio. Learn how it's done.
  2. Bonds & Fixed Income

    Safety and Income: Stocks and Dividends

    By Brian PerryWhile many people think of stocks as an option for portfolio growth, stocks can also be an attractive alternative for generating current income. Many stocks provide income in the ...
  3. Investing

    The 3 Biggest Misconceptions of Dividend Stocks

    To find the best dividend stocks, focus on total return, not yield.
  4. Investing Basics

    How Dividends Affect Stock Prices

    Find out how dividends affect the price of the underlying stock, the role of market psychology and how to predict price changes after dividend declaration.
  5. Trading Strategies

    Introduction To Dividends: Terms To Know And Other Basics

    Cash DividendCash payments made to stockholders, paid on a per share basis, quoted as a dollar amount or as a percentage of the current market value. Cash dividends are typically paid out of ...
  6. Investing Basics

    Stocks Basics: Different Types Of Stocks

    There are two main types of stocks: common stock and preferred stock. Common Stock Common stock is, well, common. When people talk about stocks they are usually referring to this type. In fact, ...
  7. Markets

    Investment Valuation Ratios: Dividend Yield

    By Richard Loth (Contact | Biography)A stock's dividend yield is expressed as an annual percentage and is calculated as the company's annual cash dividend per share divided by the current price ...
  8. Fundamental Analysis

    Why Dividends Matter

    Seven words that are music to investors' ears? "The dividend check is in the mail."
  9. Investing

    Using the Dividend Discount Model

    The dividend discount model is a way of applying net present value analysis to estimate the future dividends a stock will pay. Those dividends are then discounted back to their present value. ...
  10. Markets

    Due Diligence On Dividends

    Understanding dividends and how they work will help you become a more informed and successful investor.
  1. Dividend Discount Model - DDM

    A procedure for valuing the price of a stock by using predicted ...
  2. Current Dividend Preference

    A safety feature of preferred shares, whereby holders of such ...
  3. Preferred Dividend

    A dividend that is accrued and paid on a company's preferred ...
  4. Supernormal Dividend Growth

    A period of time in which the dividends issued on shares of a ...
  5. Participating Preferred Stock

    A type of preferred stock that gives the holder the right to ...
  6. Dividend

    A distribution of a portion of a company's earnings, decided ...
  1. When can I use the Dividend Discount Method (DDM) to value a stock?

    Learn about the dividend discount model and when it can most appropriately be used to measure the value of a stock by fundamental ... Read Answer >>
  2. How can I use the Dividend Discount Model (DDM) effectively for a stock with fluctuating ...

    Find out how the dividend discount model is applied to stocks with irregular dividend payments and how firms with irregular ... Read Answer >>
  3. How do I find the information needed for input into the Dividend Discount Model (DDM)?

    Learn where analysts and investors can find the three pieces of necessary information that allow them to calculate the dividend ... Read Answer >>
  4. What is common stock and preferred stock?

    Learn about the differences between common and preferred shares. Explore situations where preferred shares have more favorable ... Read Answer >>
  5. What is the difference between the equity market and the stock market?

    Discover the basic information about the equity, or stock, market and the two primary classifications of equities that are ... Read Answer >>
  6. Why should a company buy back shares it feels are undervalued instead of redeeming ...

    Discover the difference between common stock and preferred stock. When is repurchase preferable to redemption, and what factors ... Read Answer >>
Hot Definitions
  1. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  2. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  3. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  4. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  5. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  6. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
Trading Center