It's time to dust off one of the oldest and most conservative methods of valuing stocks: the dividend discount model (DDM).
This is one of the basic applications of financial theory that is taught in any introductory finance class. The theory is easy to grasp. A stock is worth its price if that price is exceeded by the net present value of its estimated current and future dividends.
But the model requires loads of assumptions about companies' dividend payments and growth patterns and even the direction of future interest rates. The complexities arise in the search for sensible numbers to fold into the equation.
- The dividend discount model allows the investor to determine a reasonable price for a stock based on an estimate of the amount of cash it will return in current and future dividends.
- DDM is one way of estimating the intrinsic value of a stock.
- It is most useful to investors in deciding which dividend-paying stocks to buy and hold long-term.
- It is not useful for evaluating high-growth stocks. They don't pay dividends and are purchased primarily for their price growth potential.
Understanding the Dividend Discount Model
Here is the basic assumption of the DDM: A stock is ultimately worth no more than what it will provide an investor in current and future dividends.
In general, any stock can be considered to be worth all of the future cash flows that are expected to be generated by the firm, discounted by an appropriate risk-adjusted rate.
So, to value a stock using the DDM, you must calculate the total value of the dividend payments that you think a stock will produce in the years ahead.
The Problem of Forecasting
Proponents of the dividend discount model say that only consideration of future cash dividends can give you a reliable estimate of a company's intrinsic value. Buying a stock for any other reason – say, paying 20 times the company's earnings today because somebody will pay 30 times tomorrow – is mere speculation, not investing.
In truth, the dividend discount model requires an enormous degree of speculation as it involves trying to forecast future dividends. Even when you apply it to steady, reliable, dividend-paying companies, you still are making plenty of assumptions about their future performance.
"Garbage In, Garbage Out"
The model is subject to the software code writer's axiom "garbage in, garbage out," meaning that a model is only as good as the assumptions it is based upon. Furthermore, the inputs that produce valuations are always changing and are susceptible to error.
The first big assumption that the DDM makes is that dividends are steady, or grow at a constant rate indefinitely. Even for steady, reliable, utility stocks, it can be tricky to forecast exactly what the dividend payment will be next year, never mind a dozen years from now.
Multi-Stage Dividend Discount Models
In real life, the performance of most companies varies from quarter to quarter and year to year depending on any number of unpredictable factors. The dividends the companies pay will vary according to their profits.
To get around the problem posed by unsteady dividends, multi-stage models take the DDM a step closer to reality by assuming that the company will experience differing growth phases. Stock analysts build complex forecast models that reflect many phases of differing growth in order to better reflect real prospects. For example, a multi-stage DDM may predict that a company will have a dividend that grows at 5% for seven years, 3% for the following three years, and then at 2% in perpetuity.
However, this approach brings even more assumptions into the model. It doesn't assume that a dividend will grow at a constant rate, but it must guess when and by how much a dividend will change over time.
Investors build a DDM using one of a number of assumptions. These may include an assumption of zero dividend growth, steady dividend growth, or variable dividend growth.
What Should Be Expected?
Another sticking point with the DDM is that no one can know for certain the appropriate expected rate of return to use. It's not always wise simply to use the long-term interest rate because the appropriateness of this can change.
The Growth-Stock Problem
No DDM model, no matter how complex, is able to solve the problem of predicting the future cash flow of high-growth stocks. Most growth stocks don't pay out dividends. Rather, they reinvest earnings into the company with the hope of providing shareholders with returns by means of a higher share price.
If the company's dividend growth rate exceeds the expected return rate, you cannot calculate a value because you get a negative denominator in the formula. Stocks don't have a negative value. Consider a company with a dividend growing at 20% while the expected return rate is only 5%: in the denominator (r-g), you would have -15% (5% - 20%).
In fact, even if the growth rate does not exceed the expected return rate, growth stocks, which don't pay dividends, are even tougher to value using this model. If you hope to value a growth stock with the dividend discount model, your valuation will be based on nothing more than guesses about the company's future profits and dividend policy decisions.
Consider Microsoft, which didn't pay a dividend for decades. The model might suggest that the company was worthless during those years, which would be absurd.
Remember, only about one-third of all public companies pay dividends. Furthermore, even companies that do offer payouts are allocating less and less of their earnings to shareholders.
Questions & Answers
How Do You Create a Dividend Discount Model for a Stock in Microsoft Excel?
A straightforward DDM can be created by plugging just five numbers into a Microsoft Excel spreadsheet:
- Enter "stock price" into cell A2
- Enter "current dividend" into cell A3.
- Enter "expected dividend in one year" into cell A4.
- Enter "constant growth rate" in cell A5.
- Enter the required rate of return into cell B6 and "required rate of return" in cell A6.
Is the Dividend Discount Model Flawed?
The dividend discount model may be most useful to the investor who want to identify stocks that are likely to return profits to shareholders in the form of dividends that justify the price of buying and holding the shares.
It has little meaning to the speculator who is buying shares in hopes of flipping them for a profit.
In any case, the dividend discount model can be a useful way of evaluating the current price of a stock. Is a stock undervalued or overvalued? To find out, estimate how much it is likely to return to its owners in the future.
What Does It Mean When the Dividend Discount Model Is Lower Than the Selling Price?
If the DDM value is lower than the stock's current selling price, the stock appears to be overvalued. If the DDM value is higher than the stock's current price, it appears to be undervalued.
The Bottom Line
The dividend discount model is not the be-all and end-all for valuation. That being said, learning how it works encourages thinking about the real value of a stock.
It forces investors to evaluate different assumptions about growth and future prospects. If nothing else, the DDM demonstrates the underlying principle that a company is worth the sum of its discounted future cash flows. Whether or not dividends are the correct measure of cash flow is another question.
The challenge is to make the model as applicable to reality as possible, which means using the most reliable assumptions available.