Dividend Discount Model (DDM)

Dividend discount model is one of the better known models of valuating common shares and, to an extent, a preferred method to other discounted cash flow calculations. The basic assumption of the dividend discount model is that the value of a common share can be calculated as follows:

V = D / (1+r)t

Whereby:

• V = value (or price)
• D = dividend during period “t”
• r = required rate of return on stock “abc”
• t = time period

Multiple-year Holding Period

Although dividends on a common stock could be paid indefinitely, an investor is not likely to hold the stock forever. If, for example, the investor has held the stock ABC for two years, the following formula applies:

V = [Dividend in year one/(1+r)] + [Dividend in year two/(1+r)2] + Stock ABC sale price/(1+r)2]

This formula appears relatively easy because it assumes future dividends are known. However, in most instances, analysts need to estimate future dividend payments. Estimates of future dividends depend on the outlook for a company’s earnings growth and on the firm’s dividend policy.

Both assumptions are easy to explain. First, since dividends are paid out of a company’s earnings, analysts would like to know what, if any, is the company’s earnings growth rate. Second, the easiest assumption is that the company enjoys sustainable earnings growth rate, as well as the stable and continuous dividend payout rate.

Infinite Period Dividend Discount Model

The infinite DDM assumes that dividends will grow at a constant rate (g) and that this rate is sustainable for an infinite period. Also, the infinite DDM assumes that the required rate of return (r) is greater than the dividend growth rate (g) because if it is not, the dividend discount model becomes meaningless.

The basic infinite DDM formula:

V = Dividend (Expected) / Required Rate of Return (r) – Dividend Growth Rate (g)

Whereby:

• Dividend (Expected) = Dividend (Current) x (1 + Dividend Growth Rate), or
• Earnings per Share (EPS) x Retention Rate
• Required Rate of Return = Investors can utilize the CAPM calculation
• Dividend Growth Rate = Return on Equity (ROE) x Retention Rate
• Retention Rate = 1 – Payout Rate
• Payout Rate = Dividend (Current) / EPS (Current)

Investors should note that even as small a change as one percent in either the required rate of return or the dividend growth rate generates a significant difference in the estimated value of a stock. In other words, the spread between “r” and “g” is the crucial component of the infinite DDM calculation. So, when the spread narrows, the estimated value of a stock increases. Alternatively, when the spread widens, the estimated value of a stock decreases.

Impact of DDM Assumptions in Case of Growth Companies

Growth companies are generally defined as those that have both the means and opportunity to earn rates of return that are consistently above their required rates of return. However, to exploit more exceptional investment opportunities, growth companies typically tend to retain much of their earnings for reinvestment and capital projects. This is likely why their earnings grow at a faster rate than earnings of more established, slower-growth companies.

As explained earlier, note that a company’s dividend growth rate is a function of the company’s return on equity (ROE) and its retention rate (earnings that the company retains for investments and does not pay out in the form of dividends). But since the earnings pattern for growth companies is generally higher, the pattern is generally inconsistent with the infinite period DDM.

Note that a growth company is not automatically a high-risk company, too. In fact, high-growth companies are quite capable of sustaining their high growth rates, which would even make them less risky than slow-growth companies with unstable earnings.

While in the case of growth companies the infinite period DDM model still works, in the case of periods of earnings super growth rates, the DDM model is useless, unless certain adjustments are made to the periods of super growth in addition to regular growth DDM calculations. However, this is the topic for another article soon to come.

Source: Investment Analysis and Portfolio Management, Eighth Edition, by Frank K. Reilly and Keith C. Brown, Copyright 2005.

Valuation Process Requires Both Time and Effort

Print Article

Email Article

View All Articles

How to subscribe to feeds