In recent years, there have been many personal finance novels that speak to the value of holding on to a security for a long period of time. So, in the spirit of the “buy and hold” philosophy I’d like to gesture to one of the more conservative and traditional valuation methods – the dividend discount model.
What Does Owning a Stock Mean?
There are really two key aspects of owning a stock. First, as an owner in the company you earn voting rights when the company makes decisions. But, for our purposes, the more important aspect of stocks is that you are entitled to a portion of the profits from the company.
With this in mind, there are two main ways that a stock can create value for its owner. One, managers can increase corporate value through projects generating returns above the hurdle rate.
This is what happens when APPL stock goes from being worth less than a dollar when it IPO’d to being worth around $200 now! The other way is through a dividend.
What is a Dividend?
Starting out on a very basic level. A dividend is a distribution of earnings to the shareholders of a company.
The general rule is that more mature companies (with fewer opportunities to re-invest their earnings into new projects) tend to have a higher payout ratio.
So, if you never planning on selling a stock, the only value that stock can provide to you is through dividends.
The other rationale for this model is that if you continually push out the date that you sell the equity at the discounted value of the stock will become almost nothing.
Think of this as the inverse effect of compounding interest.
The dividend discount model is really saying, if I were to hold this stock for an infinite amount of years and just collected the dividends, how much would it be worth?
Projecting Dividends
Typically, when projecting dividends, there are a few different factors to consider. Traditionally more mature companies pay out dividends that are a percentage of their EPS.
This allows for corporations to not only re-invest some earnings into new positive Net Present Value (NPV) projects, but also distribute the profits of the company to the shareholders.
So, a company can increase its dividends by increasing its payout ratio, or by increasing its net income.
Once a company pays out a certain dividend, they normally would like to payout a dividend that is greater than or equal to the previous one.
This can serve as a deterrent for companies to raise their dividends too quickly and risk sacrificing vital working capital for further expansion.
Constant Growth
When using a dividend discount model, a financial analyst will typically project out 5 – 10 years at an irregular growth rate, then taper this growth rate down over time to a long-term growth rate, normally around 2-3% in developed economies.
Although at first this may not seem intuitive let’s look at an example.
If we were projecting out what Amazon (which at the time of writing this article had a market cap of 981 Billion USD) would be worth in 200 years, and we used a long-term growth rate of 8%, how much would the company be worth?
FV = PV (Rate of Return)Years
FV = 981.85B * (1.08)200
FV = 4,751,122,649 Billion
See the problem? Given these projections, Amazon would surpass the U.S GDP! (although this might occur best to keep it out of conservative financial modeling 😊)
For this reason, financial analysts use a more conservative long-term growth rate (LTGR) below average GDP growth.
Cost of Equity
Regarding Time Value of Money discounting, we will be using a CAPM, since the DDM is based on EPS. EPS is a metric related to Net Income, so our debt holders have already been paid!
In a more advanced calculation, you could project out different CAPM values based on how the beta, risk free rate and market risk premium change over your projection period, but let’s not worry about that for now!
Dividend Discount Model Formula
Like most forms of valuation, once you understand the core concepts, the actual valuation is simple. Here is the typical formula used for DDM.
P0=D1(1+r)^1+D2(1+r)^2+D3(1+r)^3+D4(1+r)^4+((D5/(r-g))/((1+r)^4))
Where:
P0 = Price of stock at time 0
Dx = Projected dividend of stock at year X
r = Required Rate of return (calculated using CAPM)
g = Long term growth rate of the security
In this example we projected out five years of dividends, but you could easily alter the equation to project more or less years based on your research!
Clarifier – You may be curious why D5 is only being discounted four years instead of five. This is due to the (r-g) expression afterwards.
Perpetuity equations already spit out the calculation one period back so we only need to more this cash flow back four periods.
Takeaway of Dividend Discount Model
Although this method has a lot of support in the academic community, it does not see a ton of use in the financial services industry.
This is since a lot of companies are still in the “high growth” phase of their business life span. Traditionally, companies that are high growth are constantly re-investing all their earnings to complete more projects.
Conclusion
The dividend discount model excels at valuing a company are actively paying dividends. Therefore, it is used in more mature & developed industries!
Remember, as with all valuation methods, what you get out is only as good as what you put in. So, take your time doing your research to have well informed projections.
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