What Is the Dividend Discount Model?
DDM Meaning : A dividend discount model (DDM) can be described as a mathematical method that is used to predict the value of a company’s stock based on the idea that its present value is the total of the company’s potential dividend payments , when reduced down to the current value. It tries to determine the fair value of a stock regardless of the current market conditions. It also considers dividend payout rates and market expectations for returns. If the price calculated by the DDM is greater than the price of trading of shares and the stock is overvalued and is eligible for purchase as well as the reverse is true.
Understanding the DDM
A company manufactures goods or provides services to generate profits. This income generated from these business operations determines the company’s profits, which is included in the company’s price of stock. Additionally, companies pay dividends to stockholders. This usually is derived from profits of the business. It is the DDM concept is built on the notion that the worth of a business is the total of its dividends to be paid in the future.
Time Value of Money
Imagine that you loaned $100 to your friend to use as an uninterest-free credit. After a few months you return to him to retrieve the loaned amount. The friend you have spoken to gives you two choices:
- Get your $100 now
- Spend $100 on one year.
The majority of people will choose the first option. The money you earn now will permit you to deposit it into an institution. If the bank pays nominal interest rate, for example five percent, then after a year the amount you deposit will increase to $105. This is more advantageous than the other option, which is that you receive the same amount from your buddy within an entire year.
The estimation of future dividends for an organization can be an extremely complex job. Analysts and investors can make assumptions or attempt to determine patterns based on dividend payments to calculate future dividends.
One could imagine that the business has a set rate of growth of dividends to forever which is an ongoing stream of the same cash flows for an indefinite period of time, with no expiration date. For example, if the company has declared an annual dividend of $1 per share in the past year and anticipates the same growth rate of 5% of dividends and the following year’s dividend will be $1.05.
In addition, if one observes an underlying trend — for instance, a business that has paid dividends that are $2.00, $2.50, $3.00 and $3.50 in the past four years, then an assumption can be made of the dividend for this year to be $4.00. The expected dividend can be mathematically represented as (D).
Shareholders who put their money into stocks are taking an opportunity to lose money as the shares could be worth less. In order to mitigate this possibility, they are hoping for to receive a profit or compensation. Much like a landlord renting out his home to tenants, stock investors function as lending to the company and anticipate a specific rate of return. A company’s cost of equity capital is the compensation investors and the market require in exchange for holding the asset, and taking on some risk. 3 This rate of return is described as (r) and is determined by using the Capital Asset Pricing Model (CAPM) or the Dividend Growth Model. However this rate of return will become a reality only when an individual investor decides to sell his shares. The rate of return required is subject to investor decision-making.
Dividend-paying companies are required to pay dividends at a particular annual rate, shown by (g). The rate of return less the rate of growth of dividends (r – the g) is the discounting factor of the dividend of a company. The dividend is distributed and is redeemed by shareholders. The rate of growth in dividends can be calculated through multiplying yield of equity (ROE) by the retention ratio (the latter is opposite to the ratio for dividend payout). Because the dividend comes from earnings generated by the company, it should is not able to exceed the earnings. The return rate on the total stock must be higher than the growth rate of dividends in the future in order to ensure that the model might not be sustainable and could produce negative results. price that is not feasible in the real world.
Examples of the DDM
Assume Company X paid a dividend of $1.80 per share this year. The company expects dividends to grow in perpetuity at 5% per year, and the company’s cost of equity capital is 7%. The $1.80 dividend is the dividend for this year and needs to be adjusted by the growth rate to find D1, the estimated dividend for next year. This calculation is: D1 = D0 x (1 + g) = $1.80 x (1 + 5%) = $1.89. Next, using the GGM, Company X’s price per share is found to be D(1) / (r – g) = $1.89 / ( 7% – 5%) = $94.50.
A look at the dividend payment history of leading American retailer Walmart Inc. (WMT) indicates that it has paid out annual dividends totaling to $1.92, $1.96, $2.00, $2.04 and $2.08, between January 2014 and January 2018 in chronological order.8 One can see a pattern of a consistent increase of 4 cents in Walmart’s dividend each year, which equals to the average growth of about 2%. Assume an investor has a required rate of return of 5%. Using an estimated dividend of $2.12 at the beginning of 2019, the investor would use the dividend discount model to calculate a per-share value of $2.12/ (.05 – .02) = $70.67.