Stock Valuation: What is Dividend Discount Model (DDM)?

Dividend Discount Model (DDM) – It makes sense to conclude that the only cash flow you will receive from a publicly listed firm until you sell the shares will be dividends if you are investing for the long term.

Stock Valuation: What is Dividend Discount Model (DDM)?

Stock Valuation: What is Dividend Discount Model (DDM)?

Therefore, it may be justified to estimate the dividend cash flow you’ll receive while keeping the stock before purchasing. The dividend discount model (DDM) use the same methodology to determine a stock’s value.

The dividend discount model, or DDM for short, is a technique of valuation used to determine a firm’s intrinsic value by discounting the anticipated dividends that the company would pay (to its shareholders in the future) to its current value.

Once this value has been determined, it may be compared to the stock’s current market price to determine if it is overpriced or fairly valued.

It’s okay if you’re having a little trouble understanding this idea right now. You will understand this model in full if you read the entire post.

What is Dividend Discount Model (DDM)?

The dividend discount model seeks to determine a stock’s intrinsic value by calculating the expected value of the future cash flow it will provide through dividends.

The net present value (NPV) and temporal value of money (TVM) concepts are the foundation of this valuation methodology.

This easy formula is used by the dividend discount model:

Here,

P equals stock value
dividends per share
Discount rate is r. (also known as the required rate of return or cost of equity)
g is the anticipated dividend growth rate.

Two key assumptions are future dividend payments and growth rate when utilising the dividend discount model to determine a stock’s worth.

Limitations: Businesses that don’t pay dividends cannot use the Dividend Discount Model (DDM).

Calculations

A. Dividend growth rate (g):

The company’s past dividend growth may be used to calculate the dividend growth rate (g).

Furthermore, the return on equity (ROE) and retention rate figures may be used to compute the dividend growth rate. The following formula may be used to determine the dividend growth rate:

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Dividend growth rate = ROE multiplied by retention rate

Whereas Net Income = (1 – Payout Ratio)/Net Income = (Retention Rate – Dividends)

Dividend growth rate therefore equals ROE plus (1 – payout ratio)

By analysing the financial accounts of the firm, ROE and payout ratio may be calculated. Referring to financial websites like Trade Brains Portal, Money Control, etc. would be a simpler strategy. Most financial websites list these figures.

B. Discount rate or Rate of return (r):

If you wish to invest in the dividend discount model and receive an annual return of 10%, you should calculate the rate of return (r) as 0.10 or 10%.

Furthermore, the Capital asset pricing model may be used to compute r. (CAPM). According to this methodology, the risk-free rate and the risk premium are added to determine the discount rate.

The difference between the market rate of return and the risk-free rate of return, multiplied by the beta, is used to determine the risk premium.

capm
As an illustration, if a company’s beta is 1.5, the risk-free rate is 3% and the market rate of return is 7%.

Risk premium is equal to ((7 % – 3%)x1.5) = 6 %.

Risk-free rate divided by risk premium equals 3 percent plus 6 percent, or 9 percent, as the discount rate, r.

TYPES OF DIVIDEND DISCOUNT MODELS

Now that you are familiar with the fundamentals of the dividend discount model, let’s move on to the three different varieties.

  1. Zero Growth Dividend Discount Model
  2. Constant Growth Dividend Discount Model
  3. Variable Growth Dividend Discount Model

1. Zero Growth Dividend Discount Model

The Zero Growth Dividend Discount Model makes the assumption that all dividend payments made by the corporation will always be the same (until infinity).

The dividend growth rate (g) is therefore 0 in this instance.

as dividend is constant during the course of a firm
The dividend is paid in the first year, the second year, and the third year.
Div1 = Div2 = Div3 = Div4, etc.

The share value calculation for the dividend discount model with zero growth is as follows:

or Stock Value (P) = Dividend/r

Let’s use an illustration to deepen our understanding of this.

Example 1: Assume that business ABC pays a fixed yearly dividend of Rs. 1 per share for all time (lasting forever). The stock must yield a 5 percent return in order to be profitable. So what should the price be to buy shares of ABC Company?

Expected return/required rate of return (r) in this case equals 5%

Dividend (Div) equals Rs 1 and is constant.

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Stock value (P) equals Div/r =1/0.05 = Rs 20.

Therefore, to attain the requisite rate of return of 5% annually, the purchase price of the stock ABC should be less than Rs 20.

The Zero Growth Dividend Discount Model has certain limitations.

The dividend paid out per share is anticipated to rise as the firm expands. The dividend can never remain constant indefinitely.

2. Constant Growth Dividend Discount Model

This dividend discount model makes the assumption that dividend growth is constant throughout time. Throughout the existence of the firm, they have remained steady and unchanging.

The Gordon growth model is the most prevalent model utilised in the continuous growth dividend discount concept (GGM)

Gordon Growth Model (GGM):

  • Div= Dividend at the zeroth year.
  • r = company’s cost of capital/ required rate of return
  • g=constant growth rate of dividends till perpetuity

Here, Div1 is the anticipated dividend per share for the first year, which is equal to Div (1+g).

In the paradigm of continuous growth dividend discount,

model for discounting dividends with ongoing growth
Note: You can find the formula’s derivation here if you’re interested.

Let’s work through an example to determine a company’s share price using the Gordon growth model.

Example 2: Assume that QPR, a corporation, will always have a 4 percent annual dividend growth rate. The corporation distributed a dividend of Rs 5 per share this year.

The corporation must also earn a minimum rate of return of 10% annually. What therefore ought to be the cost of a share of firm QPR?

Here,

  • Div= Dividend at zeroth year = Rs 5
  • r = required rate of return = 10%
  • g= constant growth rate of dividends till perpetuity= 4%

Limitations of Gordon Growth Model:

Here are a few actual Gordon growth model restrictions when using the constant growth dividend discount model.

For the majority of businesses, the perpetual constant growth rate is invalid. Additionally, the dividend growth rate of newer corporations varies throughout the first few years.

The inputs have an impact on the computation. The expected value of the share might fluctuate significantly with even a modest change in the input assumption.

high rate of growth. The value of the share price will turn negative, which is not practical, if the dividend growth rate exceeds the needed rate of return, or g>r.

3. The multi-level/Variable Growth Dividend Discount Model:

The dividends model’s multi-level growth rate may be divided into two or three phases (according to the assumption).

The dividends rise at a high pace in the early years of the DDM Model’s two-stage growth rate before growing at a lower, constant rate in subsequent years.

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The first stage of the DDM Model for three-stage growth will also have a quick beginning phase, a slower transition phase, and finally an end with a reduced rate for an indefinite duration.

As an illustration, the dividend of business XYZ may increase at a rate of 5% for the first seven years, 3% for the following four, and eventually 2% forever.

Limitation:

The largest flaw in the dividend discount model’s multi-level growth rate is how challenging it is to predict the growth rate in narrowly defined time periods.

When the increase is divided across various levels, there are numerous uncertainties that must be taken into account.

Problems of forecasting value using DDM:

The following are some typical drawbacks of utilising the dividend discount model to anticipate share value:

  • Plenty of assumptions about the dividend growth and company’s future.
  • This valuation model is good only as far the assumptions are good.
  • Most of the inputs of DDM model keeps on changing and susceptible to error.
  • Not feasible for few categories of stocks like Growth stocks. These stocks pay little or no dividends but rather use the company profit in their growth. DDM might never find these stock
  • suitable for investment no matter how good the stock is.

Conclusion:

Due to the dividend discount model’s shortcomings, as were explained above, the majority of analysts ignore it when determining the stock price.

DDM is still a valuable technique for assessing some particular equities, such as those that offer reliable dividends. The dividend discount model is an easy-to-understand technique for company valuation. It shows how the stock value may be determined using a straightforward method of discounting future cash flows.

In any case, we strongly advise against ever buying a stock based only on its DDM valuation. Before making an investment, cross-verify the results using other financial metrics like ROE, PE, etc.

Finally, we would want to point out that while DDM has received criticism for being underutilised, it has still demonstrated value in the past. Warren Buffett, one of the best investors of all time, also provided an incredible comment about valuation.

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