Dividend discount model (DDM)

Dividend discount model (DDM) is a very common stock valuation method.  Many books and websites already have very good explanation on the model, thus I am not going to elaborate more on it.  What I am going to show today is the impact of each variable to the estimated stock price.

Not all stock can be evaluated using DDM.  As the name imply, only stock that consistently paying dividend is suitable for DDM.  Other important criteria include

The willingness of the company to pay dividend.

The ability of the company to pay dividend.

 Investors are required to hold the stock perpetually.

     

·        Let’s get familiar with the math.

Stock value = D1/(k – g)

Where,

D1 – projected next year dividend, or [dividend now * (1+g)]

k – required rate of return

g – dividend growth rate

Among these three variables, the dividend growth rate, g is the trickiest variable to estimate.  One simple method is to use the earning retention rate (RR) multiply with return on equity (ROE).  You can read more by googling “g = RR*ROE”.

The following table shows the DDM results for a stock that gives 5% dividend yield, currently trading at $1.00.  By setting g = 0%, with required rate of return = 5%, the DDM result will be same as current stock price because the stock price now is yielding 5% return.  At k = 10%, DDM result is $0.50 because you need to buy the stock at a lower price in order to meet your 10% required return.

Table 1.

Stock price now	Dividend now	Dividend Yield	D1	k	g	DDM
1.00	0.05	5.00%	0.05	10%	0%	0.50
1.00	0.05	5.00%	0.05	9%	0%	0.56
1.00	0.05	5.00%	0.05	8%	0%	0.63
1.00	0.05	5.00%	0.05	7%	0%	0.71
1.00	0.05	5.00%	0.05	6%	0%	0.83
1.00	0.05	5.00%	0.05	5%	0%	1.00

Let’ now look at Table 2.

Assuming that the dividend can grow at 2% every year, the DDM result for 5% required return is $1.70, which means the current stock price is very attractive because it can easily meet your 5% required rate of return.  But if your required rate of return is 10%, the DDM result is $0.64, which means at $1.00 current stock price, you will never able to achieve 10% return.

Table 2.

Stock price now	Dividend now	Dividend Yield	D1	k	g	DDM
1.00	0.05	5.00%	0.051	10%	2%	0.64
1.00	0.05	5.00%	0.051	9%	2%	0.73
1.00	0.05	5.00%	0.051	8%	2%	0.85
1.00	0.05	5.00%	0.051	7%	2%	1.02
1.00	0.05	5.00%	0.051	6%	2%	1.28
1.00	0.05	5.00%	0.051	5%	2%	1.70

In summary, the most important parameter in the DDM is the growth rate, g.  The accuracy of the DDM is governed by the precision of g estimation.