Dividend Discount Model - DDM

What Is the Dividend Discount Model?

All the dividend discount model (DDM) is a quantitative method utilized for foreseeing the price of a company's stock based on the theory that its present-day price is worth the sum of its future dividend payments while discounted back to their current value. It endeavors to compute the fair value of a stock regardless of the overall market conditions and thinks about the dividend payout factors and the market expected returns. In the event that the value got from the DDM is higher than the current trading price of shares, then the stock is undervalued and fits the bill for a buy, and vice versa.

Figuring out the DDM

A company produces goods or offers services to earn profits. The cash flow earned from such business activities decides its profits, which gets reflected in the company's stock prices. Companies likewise make dividend payments to stockholders, which normally begins from business profits. All the DDM model is based on the theory that the value of a company is the current worth of the sum of its future dividend payments.

Time Value of Money

Envision you gave $100 to your companion as a without interest loan. After some time, you go to him to collect your loaned money. Your companion gives both of you options:

Take your $100 now
Take your $100 following a year

Most people will opt for the best option. Taking the money currently will permit you to deposit it in a bank. On the off chance that the bank pays a nominal interest, say 5%, following a year, your money will develop to $105. It will be better than the subsequent choice where you get $100 from your companion following a year. Numerically,
$\begin&\textbf\&\qquad\mathbf{=}\textbf\mathbf{^*(1+}\textbf\mathbf{%)}\&\hspace{2.65in}(\textit)\end$
The above model shows the time value of money, which can be summarized as "Money's value is dependent on time." Looking at it another way, on the off chance that you know the future value of an asset or a receivable, you can work out its current worth by utilizing a similar interest rate model.

Modifying the equation,
$\begin&\textbf=\frac{\textbf}{\mathbf{(1+\textbf%)}}\end$
Generally, given any two factors, the third one can be processed.

The dividend discount model purposes this principle. It takes the expected value of the cash flows a company will generate from here on out and works out its net present value (NPV) drawn from the concept of the time value of money (TVM). Basically, the DDM is based on taking the sum of all future dividends expected to be paid by the company and computing its current value utilizing a net interest rate factor (likewise called discount rate).

Expected Dividends

Assessing the future dividends of a company can be a complex task. Analysts and investors might make certain assumptions, or try to distinguish trends based on past dividend payment history to estimate future dividends.

One can assume that the company has a fixed growth rate of dividends until perpetuity, which alludes to a steady stream of indistinguishable cash flows for a limitless amount of time with no closure date. For instance, in the event that a company has paid a dividend of $1 per share this year and is expected to keep a 5% growth rate for dividend payment, the next year's dividend is expected to be $1.05.

On the other hand, on the off chance that one spot a certain pattern — like a company making dividend payments of $2.00, $2.50, $3.00 and $3.50 throughout the course of recent years — then, at that point, an assumption can be made about the current year's payment being $4.00. Such an expected dividend is numerically addressed by (D).

Discounting Factor

Shareholders who invest their money in stocks face a challenge as their purchased stocks might decline in value. Against this risk, they anticipate a return/compensation. Like a landlord renting out his property for rent, the stock investors act as money lenders to the firm and anticipate a certain rate of return. A firm's cost of equity capital addresses the compensation the market and investors demand in exchange for claiming the asset and bearing the risk of ownership. This rate of return is addressed by (r) and can be estimated utilizing the Capital Asset Pricing Model (CAPM) or the Dividend Growth Model. In any case, this rate of return can be realized just when an investor sells his shares. The required rate of return can change due to investor circumspection.

Companies that pay dividends do as such at a certain annual rate, which is addressed by (g). The rate of return minus the dividend growth rate (r - g) addresses the effective discounting factor for a company's dividend. The dividend is paid out and realized by the shareholders. The dividend growth rate can be estimated by increasing the return on equity (ROE) by the retention ratio (the last option being something contrary to the dividend payout ratio). Since the dividend is obtained from the earnings generated by the company, preferably it can't surpass the earnings. The rate of return on the overall stock must be over the rate of growth of dividends for future years, if not, the model may not maintain and lead to results with negative stock prices that are unrealistic in reality.

DDM Formula

Based on the expected dividend per share and the net discounting factor, the formula for esteeming a stock utilizing the dividend discount model is numerically addressed as,
$\begin&\textit{\textbf}=\frac{\textit{\textbf}}{\textbf{(\textit}-\textbf{\textit)}}\&\textbf\&EDPS=\text\&CCE=\text\&DGR=\text\end$
Since the factors utilized in the formula incorporate the dividend per share, the net discount rate (addressed by the required rate of return or cost of equity and the expected rate of dividend growth), it accompanies certain assumptions.

Since dividends, and their growth rate, are key contributions to the formula, the DDM is accepted to be applicable just to companies that pay out ordinary dividends. Nonetheless, it can in any case be applied to stocks which don't pay dividends by making assumptions about what dividend they would have paid in any case.

DDM Variations

The DDM has numerous varieties that vary in complexity. While not accurate for most companies, the least difficult iteration of the dividend discount model assumes zero growth in the dividend, in which case the value of the stock is the value of the dividend separated by the expected rate of return.

The most common and direct calculation of a DDM is known as the Gordon growth model (GGM), which assumes a stable dividend growth rate and was named during the 1960s after American economist Myron J. Gordon. This model assumes a stable growth in dividends a large number of years. To find the price of a dividend-paying stock, the GGM considers three factors:
$\begin&D = \text{the estimated value of next year's dividend}\&r = \text{the company's cost of capital equity}\&g = \text{the constant growth rate for dividends, in perpetuity}\end$
Utilizing these factors, the equation for the GGM is:
$\text=\frac$
A third variation exists as the supernormal dividend growth model, which considers a period of high growth followed by a lower, consistent growth period. During the high growth period, one can take every dividend amount and discount it back to the current period. For the consistent growth period, the calculations follow the GGM model. All such calculated factors are summed up to show up at a stock price.

Instances of the DDM

Assume Company X paid a dividend of $1.80 per share this year. The company anticipates that dividends should fill in perpetuity at 5% per year, and the company's cost of equity capital is 7%. The $1.80 dividend is the dividend during the current year and should be adjusted by the growth rate to track down D₁, the estimated dividend for next year. This calculation is: D₁ = D₀ x (1 + g) = $1.80 x (1 + 5%) = $1.89. Next, utilizing the GGM, Company X's price per share is found to be D(1)/(r - g) = $1.89/( 7% - 5%) = $94.50.

A gander at the dividend payment history of leading American retailer Walmart Inc. (WMT) demonstrates that it has paid out annual dividends adding up to, $1.96, $2.00, $2.04 and $2.08, between January 2014 and January 2018 in sequential order. One can see a pattern of a reliable increase of 4 pennies in Walmart's dividend every year, which equivalents to the average growth of around 2%. Assume an investor has a required rate of return of 5%. Utilizing an estimated dividend of $2.12 toward the beginning of 2019, the investor would utilize the dividend discount model to work out a per-share value of $2.12/(.05 - .02) = $70.67.

Inadequacies of the DDM

While the GGM method of DDM is widely utilized, it has two notable inadequacies. The model assumes a consistent dividend growth rate in perpetuity. This assumption is generally safe for exceptionally mature companies that have a laid out history of customary dividend payments. In any case, DDM may not be the best model to value more current companies that have fluctuating dividend growth rates or no dividend by any means. One can in any case utilize the DDM on such companies, however with an ever increasing number of assumptions, the precision diminishes.

The second issue with the DDM is that the output is exceptionally sensitive to the information sources. For instance, in the Company X model above, in the event that the dividend growth rate is brought by 10% down to 4.5%, the subsequent stock price is $75.24, which is in excess of a 20% reduction from the previous calculated price of $94.50.

The model likewise falls flat when companies might have a lower rate of return (r) compared to the dividend growth rate (g). This might happen when a company keeps on paying dividends even on the off chance that it is causing a loss or moderately lower earnings.

Involving DDM for Investments

All DDM variations, particularly the GGM, permit esteeming a share exclusive of the current market conditions. It additionally supports making direct correlations among companies, even assuming they have a place with different industrial sectors.

Investors who have confidence in the underlying principle that the present-day intrinsic value of a stock is a representation of their discounted value representing things to come dividend payments can utilize it for distinguishing overbought or oversold stocks. In the event that the calculated value comes to be higher than the current market price of a share, it demonstrates a buying opportunity as the stock is trading below its fair value according to DDM.

Nonetheless, one ought to note that DDM is another quantitative device accessible in the big universe of stock valuation apparatuses. Like some other valuation method used to decide the intrinsic value of a stock, one can involve DDM notwithstanding the several other commonly followed stock valuation methods. Since it requires heaps of assumptions and forecasts, it may not be the sole best method for basing investment choices.