Tuesday, April 9, 2013

What is Dividend Discount Model

The dividend discount model (DDM) is a way of valuing a company based on the theory that a stock is worth the discounted sum of all of its future dividend payments. In other words, it is used to value stocks based on the net present value of the future dividends. The equation most widely used is called the Gordon growth model. It is named after Myron J. Gordon, who originally published it in 1959.

The oldest discounted cash flow models in practice tend to be dividend discount models. While many analysts have turned away from dividend discount models on the premise that they yield estimates of value that are far too conservative, many of the fundamental principles that come through with dividend discount models apply when we look at other discounted cash flow models.

The variables are: P is the current stock price. g is the constant growth rate in perpetuity expected for the dividends. r is the constant cost of equity for that company. D_1 is the value of the next year's dividends. There is no reason to use a calculation of next year's dividend using the current dividend and the growth rate, when management commonly disclose the future year's dividend and websites post it.
P = \frac{D_1}{r-g}
Some properties of the model
a) When the growth g is zero the dividend is capitalized.
P_0 = \frac{D_1}{r}.
b) This equation is also used to estimate cost of capital by solving for r.
r = \frac{D_1}{P_0} + g.

Problems with the model                                                                               
a) The presumption of a steady and perpetual growth rate less than the cost of capital may not be reasonable.
b) If the stock does not currently pay a dividend, like many growth stocks, more general versions of the discounted dividend model must be used to value the stock. One common technique is to assume that the Miller-Modigliani hypothesis of dividend irrelevance is true, and therefore replace the stocks's dividend D with E earnings per share. However, this requires the use of earnings growth rather than dividend growth, which might be different.
c) The stock price resulting from the Gordon model is hyper-sensitive to the growth rate g chosen.

The dividend discount model is a reasonable valuation technique for those interested mainly in dividends. The key to using it correctly is being conservative about growth projections and using a reasonable discount rate. Being too optimistic will lead to inflated values and a poor rate of return.