The Dividend Discount Model (DDM) is a valuation method that uses Dividends instead of Free Cash Flow to calculate Intrinsic Value. The Intrinsic value of a stock is the sum of all the expected future dividends, discounted back to a present value.

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The Dividend Discount Model explained.

The Dividend Discount Model (DDM) uses the same methodology as the Discounted Cash Flow Model (DCF) to determine the intrinsic value of a company. The DCF theory is that the value of a company is based on all the future cash flow it can generate. This is then discounted to account for the time value of money to find its present value. However, with the Dividend Model, we use the dividend a company pays out instead of free cash flow as it is a good metric for calculating the value of a company.

This model is mostly used for valuing dividend-paying companies and is a quantitative valuation method. It uses the same inputs as the DCF Model, such as Discount Rates and Cost of Capital, to determine present value.

The true investor… will do better if he forgets about the stock market and pays attention to his dividend returns and to the operation results of his companies.

Benjamin Graham

There is an ongoing debate in the financial world that states free cash flow can be manipulated. Therefore, dividends are considered to be the only true “cash flows” that shareholders can receive. This is why the growth of dividends over time is the primary focus for a range of investors. The DDM implies that the value per share of a company is equal to the sum of the present value of all expected dividends paid out to shareholders.

We can understand why dividends are a primary focus for investors. As we learned in the Dividend Investor blog, dividend distributions have been one of the major contributors to overall returns for shareholders.

Why is the Dividend Discount Model important?

For income-focused investors, dividends are the primary focus. Investors seek returns in many ways, whether it’s capital growth in the long term or generating income to spend now, dividends play a vital role in overall investment returns. The Dividend Yield is crucial, whether investors choose to draw the income as cash or reinvest the dividends.

Dividends are positive cash flows paid out to shareholders, so a sensible valuation choice is the DDM over a DCF Model. If a company generates free cash flow, it can reinvest in growth, issue a share buyback, pay down debt or declare a distribution. Expected returns consider the dividend yield in combination with multiple expansion and earnings growth to estimate the early returns investors can expect. So using the Dividend Discount Model in combination with an Expected Yearly Returns formula can be a great combination.

Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.

John D. Rockefeller

Holding dividend-paying companies and reinvesting the dividends can create amazing results over the long term through compounding. To ensure that you are buying them at reasonable prices, the dividend discount model is useful to place a value on those businesses. The stability and consistency of the dividend are also essential factors to consider in the DDM. Investors should understand the Dividend Payout Ratio and how it works in unison with dividend-paying companies.

It is important to note that the Dividend Discount Model is reserved for only dividend-paying companies. It has little value in valuing high-growth companies or businesses that reward shareholders in other ways such as buybacks. Not all positive free cash flow-generating companies pay out their cash to shareholders. They may have better opportunities to reinvest that cash at higher rates of return instead of paying it out.

What is the formula for the Dividend Discount Model?

The Dividend Discount Model formula has two essential assumptions: the growth rate of the dividend and the expected dividend next year. Therefore, this model works best for companies that have a stable and consistent dividend payout with a track record.

• Price Per Share = D ÷ (g-r)
• D = Dividend Next Year (Expected Dividend)
• G = Cost of Equity
• R = Growth rate of the dividend.

Stable does not mean only large-caps. Even smaller companies can pay consistent dividends with a low payout ratio, which is ideal as it means the company is keeping enough cash to fund expansion while still being able to reward shareholders. This alignment is positive because, as the company grows and generates more free cash flow, there is a likely chance that the dividend payout will increase as it uses less cash to grow and pays out more dividends.

For instance, suppose a company has a payout of 20%. In that case, it means 20% of the cash flow is paid out to shareholders while retaining 80% for whatever other needs management sees fit.

The payout ratio is essential because if an unstable company is paying out a high portion of cash flow as dividends, it means it is not keeping enough to fund growth or keep enough cash aside should things not pan out well. The first thing to go in troubled times is the dividend.

Therefore, always be mindful of the payout ratio to safely estimate the growth rate in line with what the company can realistically pay out.

Why use the Cost of Equity?

In the DDM (Dividend Discount Model), the denominator is calculated by subtracting the expected dividend growth rate from the Cost of Equity, which is determined using the Capital Asset Pricing Model. This discount rate is essentially the minimum required rate of return that equity shareholders expect to receive on their investment.

It’s worth noting that discount rates can vary, and the most commonly used ones are the Weighted Average Cost of Capital and the investor’s own desired returns. However, in the case of dividends, we use the Cost of Equity, which is only relevant to equity shareholders and not bondholders.

When calculating the discount rate for all stakeholders, including Debt Issued, Equity, and Preferred Stock, we use the Weighted Average Cost of Capital. But when it comes to dividends, we only consider equity shareholders, as dividends are paid out of retained earnings and only attributed to them.

Therefore, we use the Cost of Equity as the input for calculating the discount rate for equity shareholders in the DDM model. The DDM is not ideal for any company with rates of return (cost of equity) lower than the dividend growth rate.

*(All this technical stuff is taught in modern finance schools. Whether you are a proponent of it or not, it is helpful to understand all the jargon).

The variations of the DDM.

There are different versions of the Dividend Discount Model, each of which depends on the company being evaluated and its history of dividend payouts, consistency of payouts, and level of maturity.

The more stable and predictable a company’s dividends, the simpler the model will be. The dividend policy will also play a crucial role, as it determines how the dividend changes over time.

Where the dividend discount model becomes complex is where a company has an evolving dividend policy as it grows through the stages of its business life cycle. As companies cross the threshold and start to become profitable and generate free cash flow, they start to increase their dividends.

The dividend payout ratio changes so each year’s estimated dividend changes with it. The other concern is it does little to account for dividend-paying companies that may fall into trouble and then axe or reduce the dividend.

Gordon Growth Model (GGM)

The most widely used model is the Gordon Growth Model (GGM), also known as the constant growth DDM. It assumes a fixed growth rate (perpetuity rate) for the entire forecast period, making it much easier to use.

This model is best suited for mature companies with a long history of dividend payouts, such as “dividend aristocrats.”

Multi-Stage DDM

Then there’s the multi-stage DDM, which is intended for companies with fluctuating dividends or those that are new to dividend payments. The multi-stage model divides the forecast into two periods: the initial phase of growing dividends and the final phase of stable dividend growth.

This model requires a higher degree of forecasting and involves modelling. The forecast periods are estimated based on the dividends paid out during the different stages of a business. The forecasted period is based on: an Initial phase, a slower transition phase, and then ends with the lower stabilised rate as the perpetuity growth rate.

For example, say a company is increasing its dividend at 1% a year, increasing its payout ratio at the same time until it matures. The dividend will be different every year. The Multi-Stage DDM works to estimate the sum of all these future dividends, plus the selling price, discounted back to present value.

Zero-Growth Model

There is also a Zero-Growth model that implies all dividends remain the same forever. There is also a one-time model which is for short-term holders that may sell in a year. This model considers only the dividend and the future stock price as that is the cash flows expected to be received in a shorter time frame.

The one-time model values dividend payments based on the holding period and the exit price and discounts it based on the holding time frame. There is not perpetuity involved.

An example using the Dividend Discount Model?

Let’s run through a couple examples. We will use the Gordon Growth Model (GGM) as our first example and then run through a Multi-Stage DDM example.

The Gordon Growth Model is simple to use on the basis that the company is stable, has a consistent dividend and has a long track record of delivering the dividend. Let’s assume the expected dividend next year will be $2.75.

The dividend has grown year on year between 3-5%. We average this out and take 4% as our dividend growth rate. For the cost of equity, we will use 9% as our expected rate of return as equity holders.

• Next Year’s Dividend: $2.75
• Dividend Growth Rate: 4%
• Discount Rate (Cost of Equity): 9%

The Intrinsic Value of the company using the basic DDM formula is simply:

$2.75 ÷ (9% – 4%) = $55

Our intrinsic value per share is $55. If the current share is trading at $60, we can say the current estimation is undervalued. If the intrinsic value is higher than the current stock price it may be overvalued. This model is a very fast way to determine the value of a stable dividend-paying stock.

A Multi-Stage Dividend Model example.

Now we run through an example of the more complicated approach using a multi-period model. This model will require some stages to get to the intrinsic value per share. The first step is laying out all the inputs.

We are valuing a company that has had some stability in the dividend growth rate, yet we anticipate a slowdown after a few years. The dividend growth rate has been stable at 5% a year. So, we will use this as our initial period between year one and year five. We plan to hold the company for 10 years. So, the maturing stage will be from year five to year ten, during which we will use a lower dividend growth rate of 3.5%. Assuming the dividend will grow into the future we will shrink this perpetuity rate in the final stages to 2%. We determined the cost of equity for the firm is 7.5%.

Let’s lay out our assumptions.

What are the issues using the Dividend Discount Model?

Like all valuation models that rely on forward-looking assumptions, they are not perfect. The DDM is not different.

There are a lot of inputs that rely on forecasting in the multi-stage models. There will be sensitivity around the dividend payouts, the dividend growth rate, and the discount factor (cost of equity).

For stable companies, I think it can be a practical exercise. However, for companies that are growing, new to dividends, or going through evolving business fundamentals, it can get tricky. This increases the chance of determining an inaccurate intrinsic value.

It is hard to know whether a company will increase its dividend, what the ratio will be, and whether it will be able to pay a dividend in the future. Management may decide to change the dividend policy. Management may choose to pay down debt and reward shareholders in other ways like buying back shares.

As a recent example, a small-cap, very strong stable company was issuing dividends with a payout ratio of 50%. The company had no debt, and strong prospects for growth and a fantastic yield. The company started to expand in a new region and after years of stable dividends, luring in income investors, it decided to scrap the dividend and pump all money back into the company to help scale it.

Whilst it was good for shareholders who were chasing price appreciation via the business growing, it was not great for income investors who chased the yield.

The Dividend Discount Model was initially the preferred valuation tool, now it is no longer warranted.

In Summary…

The Discounted Dividend Model (DDM) is a method used to determine the fair value of a stock based on the cash flow or dividends, and the expected returns from the market. The result of this calculation is the share price, which can be compared to the current share price to determine over or undervaluation.

To accurately use the DDM, it is important to study the Dividend Policy of the company. This policy guides management in making decisions about dividends, including the structure of the dividend, such as whether it is stable, regular, or irregular. The Dividend Policy also determines other factors such as the payout ratio and anticipated growth rate.

If you are using a multi-stage model, studying the dividend policy can help in forecasting future results. However, it is important to keep in mind that all valuations are built on assumptions, so using the DDM in conjunction with other valuation tools is advised.

In addition, it is not wise to use the DDM model unless the company has a consistent history of payouts and a clearly defined dividend policy. Forecasting a 10-year dividend model for a company with only a few distributions is pointless.