Dividend discount models: Meaning, Criticisms & Real-World Uses

What Is Dividend Discount Models?

A dividend discount model (DDM) is a quantitative method used in equity valuation to estimate the intrinsic value of a company's stock based on the premise that its value is the present value of all its future dividend payments. This analytical tool falls under the broader category of fundamental analysis in finance. The DDM helps investors determine if a stock is undervalued or overvalued by comparing its calculated intrinsic value to its current market price.

History and Origin

The foundational concepts behind the dividend discount model can be traced back to John Burr Williams' 1938 book, "The Theory of Investment Value." Williams posited that the value of a stock is derived from the future cash flows it generates for its owners. His work laid the theoretical groundwork for what would later become the DDM. Eighteen years later, in 1956, Myron J. Gordon and Eli Shapiro published their work, which further developed and popularized the constant-growth form of the DDM, often referred to as the Gordon growth model (GGM). This model, named after Myron J. Gordon, provided a practical framework for calculating a stock's value based on its dividends, assuming a constant growth rate.

Key Takeaways

The dividend discount model values a stock based on the present value of its expected future dividends.
It is a core tool in equity research for assessing a stock's intrinsic value independent of market fluctuations.
The most common variation, the Gordon growth model, assumes a constant, perpetual dividend growth rate.
DDM is most suitable for mature companies with a consistent history of dividend payments.
The model's output is highly sensitive to the inputs, especially the assumed growth rate and discount rate.

Formula and Calculation

The most widely used form of the dividend discount model is the Gordon growth model (GGM). The formula for the GGM is:

$P_0 = \frac{D_1}{r - g}$

Where:

(P_0) = Current stock price or intrinsic value
(D_1) = Expected dividend per share in the next period (Dividend per share at time 0 multiplied by (1 + g))
(r) = Required rate of return (also known as the cost of equity or discount rate)
(g) = Constant growth rate in perpetuity expected for the dividends

To calculate (D_1), if (D_0) (current dividend) is known, the formula is (D_1 = D_0 \times (1 + g)). The required rate of return ((r)) is often estimated using models such as the Capital Asset Pricing Model (CAPM). The growth rate ((g)) can be estimated based on historical dividend growth, earnings per share growth, or industry averages.

Interpreting the Dividend Discount Model

The dividend discount model yields an estimated intrinsic value for a stock. This value can then be compared to the stock's current market price. If the DDM's calculated value is greater than the current market price, the stock may be considered undervalued, suggesting a potential buying opportunity. Conversely, if the DDM value is lower than the current market price, the stock might be overvalued, indicating a potential selling opportunity. The model is particularly useful for value investing strategies, where the focus is on identifying securities trading below their intrinsic worth. It also provides a structured way to think about the sources of a stock's value: its expected future dividends.

Hypothetical Example

Consider a hypothetical company, "SteadyGrow Inc.," which paid an annual dividend of $2.00 per share last year ((D_0)). Analysts expect its dividends to grow at a constant rate of 4% per year ((g)) indefinitely. An investor's required rate of return for similar investments is 10% ((r)).

First, calculate the expected dividend for the next period ((D_1)):
(D_1 = D_0 \times (1 + g) = $2.00 \times (1 + 0.04) = $2.08)

Now, apply the Gordon growth model formula:
(P_0 = \frac{D_1}{r - g} = \frac{$2.08}{0.10 - 0.04} = \frac{$2.08}{0.06} = $34.67)

Based on the dividend discount model, the intrinsic value of SteadyGrow Inc.'s stock is approximately $34.67. If the stock is currently trading at $30.00, the DDM suggests it might be undervalued. If it is trading at $40.00, it might be overvalued. This approach aids investors in making informed investment decisions.

Practical Applications

Dividend discount models are primarily used by analysts and investors to value dividend-paying stocks, particularly those of mature companies with predictable cash flow and a history of consistent dividend distributions. For example, the model can be applied in portfolio management to screen for potential investments or to re-evaluate existing holdings. Investment companies, including mutual funds, are required to establish procedures for valuing securities, which can include fair value determinations when market quotations are not readily available¹⁶, ¹⁷, ¹⁸, ¹⁹. While market value is typically used when readily available, fair value approaches like the DDM may be employed for less liquid or unquoted securities¹⁴, ¹⁵. The model can also be used in corporate finance to assess the value of a company or to evaluate the impact of different dividend policies. Furthermore, central bank actions, such as decisions by the Federal Reserve on interest rates, can influence the discount rate used in DDM calculations, thereby impacting valuations⁹, ¹⁰, ¹¹, ¹², ¹³.

Limitations and Criticisms

Despite its theoretical appeal, the dividend discount model has several significant limitations. A primary criticism is its inapplicability to companies that do not pay dividends, such as many growth stocks, or those with highly irregular dividend patterns⁸. For such companies, the DDM cannot be directly applied, or requires significant adjustments and assumptions about future dividend initiation or stability⁷.

Another major drawback is the model's extreme sensitivity to its inputs, particularly the assumed growth rate and the required rate of return. Even minor changes in these assumptions can lead to vastly different valuation results, making the model susceptible to subjective biases. The assumption of a perpetual, constant growth rate that is less than the discount rate is often unrealistic for many businesses⁶.

Furthermore, the DDM may undervalue companies that return capital to shareholders through methods other than dividends, such as stock buybacks⁴, ⁵. It also doesn't explicitly account for non-dividend-paying assets or future capital gains, focusing solely on the dividend stream as the source of value³. Critics also argue that the model oversimplifies complex market dynamics and the relationship between dividends and earnings².

Dividend Discount Models vs. Discounted Cash Flow

While both the dividend discount model (DDM) and discounted cash flow (DCF) analysis are valuation methodologies that rely on the principle of present value, they differ in the cash flow stream they discount. The DDM specifically discounts expected future dividend payments to arrive at a stock's intrinsic value. It is best suited for companies with a consistent history of paying dividends and a stable dividend growth rate.

In contrast, DCF models, such as the Free Cash Flow to Firm (FCFF) or Free Cash Flow to Equity (FCFE) models, discount the total cash flow generated by a company to the firm or equity holders, respectively. DCF is generally considered more versatile because it can be applied to a broader range of companies, including those that do not pay dividends, have irregular dividend policies, or are in early growth stages. The key difference lies in what is being discounted: dividends for DDM, and various forms of free cash flow for DCF. The choice between the two often depends on the characteristics of the company being valued and the availability of reliable data.

FAQs

What type of companies are best suited for the dividend discount model?

The dividend discount model is best suited for mature, stable companies that have a long and consistent history of paying dividends and are expected to continue doing so with a predictable growth rate. Companies in established industries, often referred to as blue-chip stocks, are good candidates.

Can the dividend discount model be used for growth stocks?

While variations of the dividend discount model exist, the standard Gordon growth model is generally not ideal for growth stocks that pay no dividends or have highly erratic dividend policies. It requires assumptions about future dividend initiation, which can introduce significant uncertainty¹. Other valuation methods, such as discounted cash flow analysis, are typically more appropriate for growth-oriented companies.

How does the required rate of return impact the DDM calculation?

The required rate of return, also known as the discount rate, is a crucial input in the dividend discount model. A higher required rate of return will result in a lower intrinsic value for the stock, as future dividends are discounted more heavily. Conversely, a lower required rate of return will yield a higher intrinsic value. This rate reflects the investor's opportunity cost and the risk associated with the investment.

Is the dividend discount model considered a conservative valuation method?

Yes, the dividend discount model is often considered a conservative valuation method, particularly because its basic forms primarily focus on dividends as the sole source of shareholder return. It may not fully capture the value created by retained earnings that are reinvested for future growth or the impact of share repurchases, which also return capital to shareholders.