Complete Guide to the Dividend Discount Model

In the age of crypto airdrops, dividends might seem like an old-fashioned idea. 👴🏻

However, in the stock market, dividends matter a lot—they make up for 40% of the total stock market return since 1930. 💰

Not only do dividends offer passive income to shareholders, but they are also an indicator that the business is generating enough profits to distribute the surplus back to investors. Albeit most dividend stocks tend to be dull and slow-moving, they have a rightful place in almost every portfolio. 

After all, no intelligent investor would want to miss out on the double benefit of regular income and price appreciation over the years, right? 

Except there’s one problem—there are countless dividend stocks listed on the market today, and in the long run, some will perform better than others. So how do we pick the winners?

Stock valuation methods like the Dividend Discount Model (DDM) can help us make this decision. This article looks at the model and how retail investors can use it; we also peek under the hood and observe how it works and what its limitations are.

So, are you ready? Let’s dive in! 👇

What is the Dividend Discount Model? 👨‍🏫

The Dividend Discount Model’s history can be traced to John Burr Williams, an American economist who contributed to several fundamental analysis concepts such as the Discounted Cash Flow. His work would also popularize the idea of intrinsic value. 

In the early 20th century, the stock market was expected to run on pure speculation (unlike today, obviously), where a popularity contest decides the prices. Then, however, Williams would come along and challenge the prevailing notions like a chad—he would claim that companies have an intrinsic value and the market prices adjust as a reflection of the change in value. So, instead of purely driven by speculation, they’re also caused by changes in the underlying business.

So, if we could find out a company’s intrinsic value before the market adjusts to it—beating the average market return becomes relatively easy. Several years later, these ideas would influence the Dividend Discount Model, first described in a 1956 paper by Myron J. Gordon and Eli Shapiro titled “Capital Equipment Analysis: The Required Rate of Profit.”

The Dividend Discount Model (DDM) is based on the same simple concept that a stock’s intrinsic value equals the income it generates over its life. Here are some quick bullet points:

• ☑️ Let’s say an investor buys $1,000 worth of stock A in 2012.
• ☑️ By 2016, the stock price has seen decent growth, and the shares are now worth $3,500.
• ☑️ However, the investor only has the $2,500 profit on paper. If they want to realize their gains, they would have to sell the shares. 
• ☑️ In this case, the total income generated by the shares would be the net profit after taxes. But the asset would also be lost and generate no future income.
• ☑️ On the other hand, if the investor holds on to their shares, the only “real” income generated by the asset is the dividend payments.

And that’s where the Dividend Discount Model comes in. It offers a formalized and sophisticated methodology to compare dividend stocks assuming that the inherent value is equal to its total dividend-paying capacity over its lifetime. 

The model uses historical data to project future dividend payments, discounts them to their present values, adds them together, and arrives at an estimate of the current intrinsic value of the stock. 

If you feel some of the words above didn’t make sense, there’s no need to worry—financial maths tends to sound more complex than it is. In the section below, we break down each aspect of the model and its maths more thoroughly.

How the Dividend Discount Model Works 📚

Since the Dividend Discount Model seeks to find the present value of future cash payments, it first needs to adjust for the time value of money.

What is the Time Value Of Money? ⏲

Money loses value over time due to factors like inflation. So, for example, even though a $100 bill in 1970 had the same founding father on it as a current $100 bill, it would have had a lot more value (and a subjectively better soundtrack). 

When adjusted for inflation, its purchasing power would be equivalent to approximately $712.86 in 2021. 

So if the value of money is affected simply by the passing of time, we need to account for the change when calculating the value of future dividend payments in today’s money  (or the Present Future Value). 

The present future value of a consistent $1,000 dividend income over the next ten years won’t be $10,000 because inflation will eat away some purchasing power over time. 

Fortunately, we can use maths to calculate the value of money over time easily. 

For example, we know that the future value of an asset, when the expected rate of return is known, can be calculated with the following equation: 

Example: What would be the value of $100 in 2 years assuming a rate of interest of 5%?

The equation can then also be converted to find out the present value if the future value and expected rate of interest (or the discounting rate) are known.

Example: What is the present value of $10,000 received ten years from now, assuming an inflation rate of 2%?

In the above example, we are using the inflation rate as the “discounting rate.” When we calculate the present value of a future cash flow, we are assuming some of it would be naturally lost since future money is less valuable than present money. To adjust for this decay, we discount the cash flow by multiplying it with the discounting factor.

Discounting Factor 🧮

The discounting factor is essentially the inverse of the discounting rate. If the discounting rate is 4% over 2 years, the discounting factor be calculated as follows:

When we multiply the future amount by the discounting factor, we get its present net value. For example, if we want to know how much $2,000 would be worth in 2 years with a 4% discounting rate as stated above, we can multiply it by 0.924. If you take a closer look, we essentially do the same thing in the previous example.

The Dividend Discount Model uses the same principle to discount future dividend payments. When all the discounted dividend payments are added together, we get their net present value. Discounting is also used in other financial analysis methods like Discounted Cash Flow (DCF) Analysis.

How Do We Know What’s the Right Discounting Factor For Dividends? 🤔

Unlike the previous examples where we adjust for inflation, we need to look at a few more factors to arrive at the appropriate discounting factor to be used in the model. There are primarily two things that we need to note: 

1. The cost of capital (r): Rate of interest expected by lenders of the firm

2. The dividend growth rate (g): Rate of growth in annual dividends

Since a firm has to pay a rate of interest on its capital every year, we can expect the net profits to be affected by the average cost of capital to the company. So, for example, a $2 dividend in the next year might only be worth $1.40 when discounted by the cost of capital for the following year. 

However, companies also tend to increase their dividends over time. Since the growth in dividend rate counteracts the adverse effects of the average cost of capital, we can adjust the discounting factor as follows:

Projections About Future Dividend Payments 🚀

To find the present value of future dividend payments, we also need to forecast the future dividend payments. While it can be tough to predict them accurately, we can still look at previous trends to make an educated guess. For example, if a company has been increasing the dividend payments by 25 cents every year, we can predict the trend to continue over the following years.

In some cases, the growth rate of dividends can vary too. For example, a new company might initially pay a low dividend but increase it exponentially as it grows. However, this is usually not the case because growth companies tend to reinvest the profits to keep growing (even though some research suggests that companies with higher payout ratios are more likely to keep generating higher profits). 

There are several variations of the DDM that account for different growth rates. All of them, however, utilize the same formula primarily.

Dividend Discount Model Formula 📝

The formula for the Dividend Discount Model is very straightforward—it simply multiplies the following year’s dividend with the discounting factor to arrive at the stock’s current value. Here’s how we can formalize the idea into an equation.

If we assume:

Then:

So:

Similarly, for dividend received in t years, we can arrive at the final formula for the model as follows:

However, in simple words, it still essentially means multiplying the expected dividend of “t” year by the discounting factor derived from the predicted rate of dividend growth and cost of capital to the company. There are other variations of the formula that adapt for different scenarios that we look at near the end of this article.

However, as you can guess, there is a fair bit of estimation with the formula. Yet, that is entirely normal when using financial models. The idea isn’t to glance into a crystal ball and see signs that nobody is seeing but rather to simulate the future based on our assumptions. In the section below, we look at how we can use the DDM practically as investors.

Using the DDM in Investing 💰

Let’s be clear—the DDM is not a magical formula that accurately estimates the actual value of any stock. Moreover, it is pretty much useless when it comes to stocks that do not pay any dividends. 

Yet, the model can help us compare dividend stocks and if they are relatively undervalued or overvalued. It offers a straightforward approach to stock valuation and helps us get an objective view based on future dividend payments.

In some cases, like picking a dividend stock to hold for the long term, DDM can still prove to be quite effective. Along with other fundamental metrics like the dividend payout ratio, free cash flow, and operating profit margin, we can use it to select the most profitable bets for the future.

The following section goes through a manual example to see how the DDM works in action with actual market data. 

Dividend Discount Model Example 📊

Instead of going through a bland example of finding the intrinsic value of a made-up company like ABC Corp., let’s see how the model can be used to find answers to questions we might have.

In this case, let’s assume the following question—given its dividend payment capacity, is JPMorgan Chase & Co. (JPM) overvalued or undervalued by the market? 

It has been a wild decade for the banking industry. After the subprime mortgage crisis, retail investors were understandably wary of big banking. However, the regulations that resulted from the crisis stabilized the industry and went on to prosper again. Despite the COVID crash, JPMorgan, in particular, seems to be thriving again.

However, its current market valuation (as of December 2021) seems to be a little bit dubious. Since the stock is a well-known dividend stock, we can use the DDM to find the stock’s intrinsic value and see how it fares up against the market value.

The DDM formula, as discussed above, is the following:

Here’s the data that we plug into the formula:

So based on the DDM formula, the fair value of JPM should be: 

The current market price for JPM is around $160 at the time of writing this article. This means JPM is currently overvalued by the market. Even though there is a pretty big difference between our calculated value and the market value, we expect the company’s price to have some sort of premium since it’s actual value is much more than just its dividends.

However, this is a good first indicator and a sign that a stock might be too overvalued. We can also calculate the intrinsic value of other competing stocks in the industry such as Bank of America (BAC) to compare them.

We can see that the market price for both is higher than the DDM value as expected. Given the recent pump, it is possible to see another correction and the DDM values would make great entry points.

If we take a look at the JPM chart, we can see that the stock was around its fair value before the sharp drop in March 2020 due to the pandemic. Since then, the stock has been rallying and has blasted off its fair valuation and has been in the overbought territory since February 2021 according to our DDM calculations.

Limitations of the DDM 🚧

Like all financial models, DDM has its fair share of limitations too. For example, the model cannot be applied to stocks that don’t pay dividends, its conservative nature, and its disconnect with the general market opinion. Let’s look at all of these limitations in-depth:

• We cannot use DDM for stocks that do not pay dividends.

In general, DDM should not be used to analyze stocks that do not pay dividends. Since there is no historical data to base our assumptions on, we will likely get them wrong. However, we can still calculate a non-dividend-paying stock’s intrinsic value by assuming its dividends. However, it is a much more contrarian approach to investing, and the model might not work correctly.

• DDM can be a bit too conservative.

Another criticism of DDM is that it can tend to be very conservative. Many believe that the value of a stock is based on several factors other than just dividends. While it is a valid criticism that the model doesn’t incorporate all elements, the other factors can be calculated separately and added to the core computed value. In addition, some advanced forms of DDM include factors like stock buybacks, making them more inclusive of other factors.

• DDM is disconnected from the modem market trends.
  
  DDM cannot handle growth stocks, especially stocks with exponential growth. It usually assumes a steady growth rate, and when it’s confronted with TSLA’s chart, for example, everything goes off balance. However, most companies that grow exponentially do not make good dividend stocks in general.

Dividend Discount Model Variations ⚖ 

We mostly looked at the basic DDM formula in this article, but there are several variations of the formula that change things up a little. Here are some of the most common variations of the Dividend Discount Model:

• Constant Growth (Gordon Growth Model) – It is the basic version of DDM and is used in this article. It assumes a steady rate of growth through perpetuity.
  
• Variable Growth – Variable Growth DDM works assuming that dividends would not grow at a steady rate. Instead, they would grow at different paces relative to the company’s lifecycle. Variable growth models can further be divided into two-stage variable growth models and three-stage variable growth models.

Conclusion 💭

Although imperfect and not applicable to every stock, the Dividend Discount Model is one of the most popular stock valuation methods today, not only by institutional “smart” money but also by retail traders looking to maximize their returns.

We hope this article proved helpful in understanding what DDM is, how and why it works, and how it can help you make better decisions regarding dividend stocks.

Get Started with a Stock Broker