What is the Dividend Discount Model?

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The discount model (DDM) is a method that investors and financial professionals use to calculate an equity’s share price by taking into account the impact of future dividend payments.

Because the American economist Murray G. Gordon originally published the model in 1956, along with Eli Shapiro, this model is also frequently called the Gordon growth model (GGM). While published in its current form and popularized by Gordon and Shapiro, the model builds heavily on John Burr Williams’ valuation ideas found in the latter’s 1938 book “The Theory of Investment Value.”

The dividend discount model’s underlying theory is that a company’s current fair share price is equal to the total of all future dividend distributions discounted to reflect the present value of all future payments. The model is fairly simple to use, since it relies on just three input variables – total estimated dividend payouts over the next 12 months, the steady annual dividend growth rate and the discount rate.

The dividend discount model formula is as follows:

Where:

P = current fair value price per share

D = total dividend payouts expected over the next 12 months

r = discount rate

g = expected dividend growth rate

Dividend Discount Model Assumptions

Because of its simplicity – requiring only three input variables that are fairly easy to obtain – the dividend discount model is easy to use and yields fast results. However, the model’s simplicity is also its main weakness. Additionally, while able to account for changes in future dividend payouts and expected returns, the model attempts to estimate the fair value of an equity’s share price without considering prevailing market conditions. Furthermore, DDM is based on multiple assumptions that isolate it from effects and considerations of real-life financial consideration. The dividend discount model assumptions are:

– The company has no debt in its capital structure.

– The company finances all investment and expansion with its retained earnings, without any external financing.

– The model assumes a constant internal rate of return is fixed and disregards an investment’s diminishing marginal efficiency.

– The business risk of all investment is equal – cost of capital is constant.

– The model assumes a perpetual stream of earnings.

– The DDM does not account for the diminishing effect of corporate taxes.

– The model assumes a constant dividend payout ratio.

– The model yields meaningful result values only if the discount rate (r) is higher than the annual dividend growth rate (g).

Example: The Coca-Cola Company

The Coca-Cola Company is a that has raised its annual dividend payout for the past 60 consecutive years. Looking back to its data in 2018, the company has paid a \$0.39 quarterly dividend distribution for a total annual dividend payout of \$1.56 for the year. However, the company hiked its quarterly payout \$0.20 for the first quarter in each of the past several years. Working with the premise that the Coca-Cola company will continue this trend, we can assume that the quarterly dividend payout will rise to \$0.41 – a 5.4% growth rate (g) – and remain at that level for the remainder of the year. Based on this quarterly dividend payout projection, we can estimate that the company will pay a \$1.64 total annual dividend (D1) in 2019. Assuming an 8% discount rate (r), and plugging the values into the DDM formula:

We get:

Under these assumptions, the fair market value of the KO stock in 2018 was \$63.08. Since the stock closed at the end of trading on December 17, 2018 at \$48.33, the DDM indicates that the stock was undervalued as the share price was more than 23% below its estimated fair value.

How would the results look if we assumed a 10% discount rate? Substituting the 10% discount rate instead of the previous 8% and keeping all other values the same, we get:

With the revised discount rate, the DDM now estimates the fair market value of the KO stock as \$35.65. In this case the current \$48.33 closing price is overvalued – 26% above the estimated \$35.65 fair market value

Inferences from the Dividend Discount Model

The management teams of stocks can use the dividend discount model and tailor their dividend payouts in alignment with a company’s. While financial experts disagree on the merits of divided distributions, the DDM delineates the potential options, which are different for companies in different stages of expansion.

For companies with minimal or no growth, the model assumes that the internal rate of return or dividend growth rate (g) is identical to the cost of capital or discount rate (r). In this case, it is theoretically irrelevant whether the company distributed dividends to shareholders or reinvested those funds back into the company’s operations. Therefore, the initial conclusion was that an optimal dividend payout ratio does not exist in this case.

While that reasoning might seem sound from the company’s point of view, shareholders generally disagree. Given the choice and absent any additional differentiating considerations, investors will generally prefer equities that pay dividends over their non-dividend-paying counterparts. Therefore, even if the DDM shows no preference, companies should always lean towards paying dividend distributions to attract investors, which should create upward pressure on the share price. Gordon also realized this notion and revised his theory later to state that even when growth rates equal discount rates, a company’s dividend policy affects its share price.

Growth mode

The internal rate of return (g) is generally higher than the cost of capital (r) for companies in growth mode. In that case, the shareholders gain higher returns from reinvesting the dividends in the company’s growth than the dividend income payouts. Therefore, the optimal dividend policy for this case has no dividend payouts.

Declining mode

A dividend policy for a company in the declining mode should have a dividend payout ratio as close as possible to 100%, which maximizes shareholders returns. Since the internal rate of return (r) is lower than the cost of capital, the shareholders benefit more from the dividend income payouts than from reinvesting dividends into the company’s operations.

Final Summary of the Dividend Discount Model

Investors can use the simple and fast analysis of the basic dividend discount model to get general guidelines about a stock’s fair valuation. However, for more encompassing portfolio investment strategies, investors must analyze the equity beyond the one-year horizon. Long-term portfolio strategies necessitate identification of dividend-paying equities with robust potential returns over extended, multi-year periods.

While simple in its original form, the dividend discount model formula is easily adaptable to more complex evaluation models. The availability of spreadsheets and customized financial analysis software allows for application of the concepts and the formulas on multi-year analysis models with variable dividend growth rates for each period.

Despite several shortcomings over extended periods, the basic dividend discount model still provides a solid foundation for equity selection analysis. However, like with any other financial metric or indicator, investors must use the dividend discount model in union with additional performance measures and evaluation methods to identify investments with the highest total return potential. In addition to considering additional evaluation metrics, investors must continue using the dividend discount model regularly for evaluating potential investments to compensate for changes in their portfolio strategies, changing performance of the target equities, as well as changing market conditions.

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Jonathan Wolfgram is an investment analyst who writes website content at Eagle Financial Publications. He graduated from the University of Minnesota with Bachelor’s degrees in Finance and Philosophy. Jonathan writes for www.DividendInvestor.com and www.StockInvestor.com.