The dividend discount model (DDM) is a quantitative method used for predicting the price of a company's stock based on the theory that its present-day price is worth the sum of all of its future dividend payments when discounted back to their present value. It attempts to calculate the fair value of a stock irrespective of the prevailing market conditions and takes into consideration the dividend pay-out factors and the market expected returns. If the value obtained from the DDM is higher than the current trading price of shares, then the stock is undervalued and qualifies for a buy, and vice versa.
The variables of the DDM are g; the constant growth rate in perpetuity expected for the dividends, r; the cost of equity capital for the evaluating company or entity, and D1; the value of the next year's dividends. These variables can be used to equate the value, V, of share or investment and determine whether it is under or over valued.
The DDM assumes that a company's dividends are going to continue to rise at a constant growth rate indefinitely. You can use that assumption to figure out what a fair price is to pay for the share or investment today based on those future dividend payments.
The cost (or return) of equity is the return a company requires to decide if an investment meets capital return requirements. Firms often use it as a capital budgeting threshold for the required rate of return. A firm's cost of equity represents the compensation the market demands in exchange for owning the asset and bearing the risk of ownership. The traditional formula for the cost of equity is the dividend capitalization model.
"D1" stands for the stock's expected dividend over the next year. For the purposes of this calculation, you can assume that next year's dividend will grow at the company's historical rate of dividend increases. If given the value for the current year’s dividend (D0), the value for next year’s dividend can be calculated by multiplying the current dividend value by the value of the growth rate plus one:
D1 = D0 * (1 + g)
The value of a share or investment (V) is the expected value of a share based on the DDM calculation. This value can then be compared to the most recent selling price of a share, currency, commodity, or precious metal that is traded on an exchange, as it is the most reliable indicator of that security's present value. Should the estimated value be higher than the current market value, it can be assumed that the investment is undervalued on the market and may present an investment opportunity, or vice versa, should the estimated value be lower than the market value of the investment then the investment may be considered overvalued.
Since the variables used in the formula include the dividend per share, the net discount rate (represented by the required rate of return or cost of equity and the expected rate of dividend growth), it comes with certain assumptions.
For example; Let's say that a certain company issued share is expected to pay a $2.00 dividend next year, and its dividend has historically grown by 4% per year, so it's fair to assume this same growth rate going forward. Assume an investor holds a desired rate of return of 10%. Using these input values, the investor can calculate the share's value using the dividend discount model as:
V = D1 / (r - g)
V = $2 / (0.1 – 0.04)
V = $33.33
Using the dividend discount model, an investor would value the company’s shares’ value to be $33.33 per share. This value is important for valuation by investors as it indicates whether shares are under or overvalued when comparing them to the market value on a stock exchange. For instance, if the DDM value calculated is lower than that of the market value, an investor may consider the shares overvalued and could make the decision to forgo investing in the security. However, if the DDM value is higher than the market value on the stock exchange, it might flag an investment opportunity for the investor as the shares may seem undervalued compared to the market price.
The dividend discount model is best used for larger blue-chip stocks because the growth rate of dividends tends to be predictable and consistent. For example, Coca-Cola has paid a dividend every quarter for nearly 100 years and has almost always increased that dividend by a similar amount annually. It makes a lot of sense to value Coca-Cola using the dividend discount model.
It is important to note that since dividends and their growth rate are key inputs to the formula, the DDM is believed to be applicable only on companies that pay out regular dividends. However, it can still be applied to stocks which do not pay dividends by making assumptions about what dividend they would have paid otherwise.
The dividend discount model was developed under the assumption that the intrinsic value of a stock reflects the present value of all future cash flows generated by a security. At the same time, dividends are essentially the positive cash flows generated by a company and distributed to the shareholders.
A company produces goods or offers services to earn profits. The cash flow earned from such business activities determines its profits, which gets reflected in the company’s stock prices. Companies also make dividend payments to stockholders, which usually originates from business profits. The DDM model is based on the theory that the value of a company is the present worth of the sum of all of its future dividend payments.
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