Dividend discount model for stocks

What is dividend discount model?

The Dividend Discount Model (DDM) is a valuation approach employed by analysts to estimate the value of a stock. It is applicable primarily to companies that have a track record of consistently paying dividends over an extended period.

The Dividend Discount Model (DDM) is a method used to estimate the intrinsic value of a stock by considering the present value of its future dividends. It assumes that the value of a stock is equal to the present value of all the dividends it is expected to pay to shareholders in the future.

The basic idea behind the DDM is that investors purchase stocks in order to receive a return on their investment, primarily in the form of dividends. By discounting the expected future dividends back to their present value, the DDM attempts to determine what a stock is worth today.

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The DDM assumes that dividends will grow at a stable rate over time. There are different variations of the model to account for different growth scenarios, such as the Gordon Growth Model, which assumes a constant growth rate, and the Two-Stage DDM, which considers different growth rates for a specific period and a stable growth rate afterward.

Example:

Imagine I present you with a retirement plan. This plan guarantees that you will receive $100 each year for the next 10 years, and at the end of the 10th year, you will receive an additional $1000. Now, the question is, how much would you be willing to pay for this plan?

While the total sum of the payments amounts to $2000 ($100 per year for 10 years plus $1000 at the end), you understand that $2000 in the future is not equivalent to $2000 today. The concept of time value of money comes into play. For instance, if I were to borrow $100 from you and return it in a few hours, you might consider it fair. However, if I ask for $100 today and promise to return it to you next year, you would expect me to compensate you more than $100. This is because if you had kept that $100 in a bank, you could have earned interest and ended up with more money.

In essence, the value of money today is considered higher than the same amount in the future due to the potential for earning interest or returns on investments. This principle is central to understanding the concept of present value and the time value of money.

Assuming the current interest rate is 5%, how much would you be willing to offer in order to receive $100 in the future? You would offer less than $100.

Let’s consider a scenario where you have $100 and you want to determine its value after one year. To calculate the future value, you would multiply $100 by (1 + the interest rate of 0.05), resulting in $105. However, if you wish to determine the value of $100 from one year ago, you would divide it by (1 + 0.05), which is approximately $95.

The same principle applies to our retirement plan. Let’s proceed with the calculations.

If we want to determine the value of $100 from one year ago, we can calculate it by dividing $100 by (1 + 0.05), which equals approximately $95.23. Therefore, the present value of $100 today is considered to be $95.

Now, let’s consider the other $100 that is expected in two years. To calculate its present value, we need to discount it by the interest rate for two years. Using the same interest rate of 5%, we can divide $100 by (1 + 0.05)^2. This gives us approximately $90.70 as the present value of $100 expected in two years.

By performing the calculations for each individual amount and determining their present values, we can then add up these present values to obtain the total.

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Each year, to discount the future values, you divide them by 1.05. This process acknowledges that the further into the future an amount is, the less valuable it is in present terms.

Therefore, the total present value of all these future payments is equivalent to the sum of their individual present values.

Hence, the worth of this plan amounts to $1386. If you are paying more than this value, it would be considered a bad deal. Conversely, if you are paying less than $1386, it would be deemed a good deal.

The same reasoning applies to stocks. If you own a stock that pays dividends annually, and you have an estimate of the expected dividend amounts, as well as an approximate idea of the future resale value of the stock, you can discount those future cash flows to determine their present value. This present value represents the worth of the stock to you today and can be considered as its price.

This is the approach analysts utilize when employing dividend discount models to determine the valuation of a stock’s price.

Imagine you have the opportunity to receive $100 per year indefinitely, and your discount rate is 5%. How much would this stream of payments be worth to you in present terms? By dividing $100 by 0.05, the result is $2000. Therefore, you would be willing to pay $2000 for an investment that generates $100 per year with a 5% interest rate.

However, it’s important to consider that dividends are not fixed and tend to grow over time. This introduces the need to incorporate a growth rate into the calculation. For instance, let’s assume the dividend for the next year is $100, the discount rate is 5%, and the growth rate is 1%. In this case, dividing $100 by the difference between the discount rate (0.05) and the growth rate (0.01), which equals 0.04, gives us $2500. Thus, the investment becomes more valuable due to the anticipated growth in dividends.

How we gonna use DDM as traders?

Determining the value of a stock based solely on dividends is not a straightforward process, as it involves two challenging aspects: calculating dividends and estimating growth. Growth rates can fluctuate, making precise calculations difficult. However, analysts typically possess insights and predictions regarding the future movement of growth rates, as well as the discount rates they employ in their calculations. These factors contribute to their assessment of a stock’s worth.

Traders are aware that analysts utilize the dividend discount model (DDM) to calculate the value of stocks that provide consistent dividends. Many stocks fall under this category and maintain a pattern of reliable dividend payments. Consequently, traders generally assume that stocks with consistent dividend payments, coupled with high institutional ownership, are typically valued using the DDM approach.

Stocks are traded at their current price because it represents the collective agreement of all traders in the market, taking into account various factors including the valuation derived from the dividend discount model (DDM). Therefore, attempting to determine the stock price solely using the DDM may not be the most accurate approach since the market price already reflects this consensus. Instead, traders focus on monitoring and analyzing changes in dividend payments as a means to assess the potential fluctuations in stock value.

Suppose a company initially pays a dividend of $1 in the first year, and the dividend gradually increases by 2% each year. However, at a certain point, the company decides to reduce its dividend to 92 cents. From this scenario, we can deduce some important insights.

Firstly, it is evident that institutional investors and stakeholders who own the stock likely utilized the dividend discount model (DDM) to assess the stock’s value, considering the historical dividend data of $1, $1.02, and $1.04.

However, with the dividend cut to 92 cents, it signifies a significant deviation from the established trend of growth. This reduction in dividend and the absence of an apparent growth trajectory can lead to a decline in the stock’s valuation. Consequently, it is expected that the stock’s value will decrease in response to this change in dividend.

Conclusion

As short-term traders, our focus is not on using the dividend discount model (DDM) to value the stock. Instead, we are interested in understanding how analysts utilize the DDM. This knowledge helps us predict how a stock will react to changes in dividends, particularly when there is high institutional ownership involved. By considering the insights provided by the DDM, we can gain a better understanding of the potential impact on the stock’s behavior and make more informed trading decisions.

This is precisely why many companies that consistently pay dividends are hesitant to cut or slow down their dividend growth. The reason behind this caution is that any reduction in dividends or a decrease in the growth rate can have a significant negative impact on the company’s stock price. This is primarily because investors closely monitor dividend-related actions, and any unfavorable changes can lead to a sharp decline in the stock’s value. Therefore, companies strive to maintain their dividend consistency and growth to preserve investor confidence and support their stock price.

By utilizing the screening feature on finviz, you can identify numerous stocks that possess both high institutional ownership and a dividend yield.

If you visit dividend.com and enter the ticker symbol of a company, you can access detailed information about that company’s dividends.