One of the problems that investors face in the stock market is determining the value of the stocks in which they plan to invest. Comparing the value of a stock to its market price allows investors to determine whether a stock is trading above or below its true value. Investors try to value stocks in a variety of ways, but one of the oldest and most fundamental is the dividend discount model.
The discounted dividend pricing model uses future dividends to predict the value of a stock and is based on the premise that investors buy stocks for the sole purpose of receiving dividends. In theory, there is a solid basis for the model, but it relies on many assumptions. However, it is still often used as a means of valuing stocks.
Let’s take a look at the theory behind the dividend discount model, how it works, and whether you should use it to assess whether to buy a stock and when.
Theory and process behind the evaluation model
Rational investors invest in securities to make money. The concept behind this model is that investors will buy a stock that will reward them with future cash payments. Future dividend payments are used to determine the current value of the stock.
To use the model, investors must accomplish certain things:
1. Approximate future dividend payments
This is not always an easy task, as companies do not offer the same dividend payments every year. Dividends are the portions of profits that companies choose to distribute to their shareholders. Companies vary these payments, but as a general rule investors generally assume that companies redistribute a certain percentage of their profits to their shareholders. Of course, this poses the added challenge of forecasting future income, which is usually accomplished by forecasting the growth or decline in sales and expenses in the years to come. They can then calculate the amount of money that should be paid out as dividends and divide it by the number of shares outstanding to determine the amount of dividends paid to each investor for each share they own.
2. Determine a discount rate for future payments
Determining the value of a stock is not as simple as adding up all future dividend payments. Payments made in the near future are considerably more valuable than those made in later years because of the time value of money. Suppose an investor plans to invest over a five-year horizon. Payments you receive after the first year can be rolled over for four years, while payments you receive after five years cannot be rolled over. Therefore, the payments you receive in a year are much more valuable. Investors need a method to discount the value of these dividends. This is accomplished by determining a required rate of return for investors, which is generally assumed to be the amount of money they could earn by investing in the stock market as a whole (usually approximate with the estimated return of the S&P index. ) or a combination of Investing in stocks and bonds that pay the current interest rate.
3. Apply the calculations to the model
The equation of the dividend discount model is:
Dividend discount model
In this model, P represents the current value of the shares, Div represents the dividends paid to investors in a given year and r is the required rate of return that investors expect given the risk of the investment.
In addition, the value of a company whose dividend increases at a constant perpetual rate is represented by the following function, where g is the constant growth rate that the dividends of the company are expected to experience over the life of the investment:
Regularly growing dividend
Using these two formulas together, the Dividend Discounted Model provides a simple technique for valuing a stock based on its expected future dividends.
Example of valuation model with dividend discount
ABC Corporation pays dividends of $ 2 per share. Investors expect an 8% rate of return on their investment. Dividends are expected to increase by 5% for one year, then by 3% each year thereafter. By applying the discount model using the two previous formulas, the investment value can be calculated for each period:
- Year 1. The investment value for this period is $ 2.00 / 1.08 = $ 1.85.
- Year 2. Dividends for this year increased to $ 2.10 per share based on the 5% growth rate. The investment value for this period should be $ 2.10 / (1.08) ^ 2 = $ 1.80
- Constant growth value. According to the constant growth equation mentioned above, the constant growth value of a stock is $ 2.10 / (0.08-0.03) = $ 42.
Value of a share of ABC Company. The value of a share is calculated using the previous two formulas to calculate the value of dividends in each period: (2.00) / (1.08) + 2.10 / (1.08) ^ 2 + 2.10 / (0.08 – 0.03) = $ 45.65 per share.
Compare to the value of a current stock. This is the most important part of the model. If a stock is trading for less than $ 45.65 per share, the stock is undervalued and they can profit by buying it. If the stock is trading above $ 45.65 a share, they may be able to profit by selling the stock short.
There are three main reasons why the dividend discount model is a popular valuation technique:
1. Simplicity of calculations
Once investors know the variables in the model, calculating a stock’s value is very straightforward. It only takes a little algebra to calculate the stock price.
2. Sound and logical basis of the model
The model is based on the principle that investors buy stocks in order to collect in the future. While there are several reasons why investors may buy a security, this basis is correct. If investors never received payment for their security, it would be worthless.
3. The process can be reversed to determine the growth rates predicted by experts.
After looking at the price of a stock, investors can rearrange the process to determine the dividend growth rates expected from the company. This is useful if you know the expected value of a stock, but want to know the expected dividends.
Although the model is still used by many investors, it has become much less popular in recent years for a number of reasons:
1. Reflect rationality, not reality
The discounted dividend model is based on the concept that investors invest in stocks that are more likely to pay them more. While this is the way investors should behave, it doesn’t always reflect how investors actually behave. Many investors buy stocks for reasons that have nothing to do with the company’s financial condition or future dividend payments. Some investors buy a business that turns out to be more glamorous or interesting. This often explains why there is a gap between the intrinsic value of a stock and the actual market value.
2. Difficulty determining the variables that enter the model
The dividend discount model is easy to use. However, it is difficult to determine the numbers that go into it, which can lead to inaccurate results. Companies are often unpredictable with their dividends, so it is difficult to predict them for this model. It is also very difficult to estimate a company’s future sales, which influences a company’s ability to maintain or increase its dividends.
3. Dividends aren’t the only way earnings are valuable to investors
Investors may be primarily concerned with dividends, but all profits remain with the investors. Dividends are only the portion of the profits that a company chooses to pay. Retained earnings are always owed to investors and always count towards your equity. This is why the new models assess the overall cash flow of a business, not the amount paid to investors.
4. Investor bias
Investors tend to confirm their own expectations. This means that most investors will generate their own values for a stock, as many of the entries here are somewhat subjective. Only those who can force themselves to be objective are likely to find precise variables for the model.
5. Sensitive valuation model
This model is very sensitive to small changes in the input variables. So it can be easy to accidentally identify a security as overvalued or undervalued if you are a little out of step with your specific input estimate.
6. Useless for valuing stocks without payment of current or future dividends
As mentioned above, investors can only receive value from a company that will pay them dividends at any given time. However, some companies do not offer dividends at a given time and are not expected to do so in the near future. Ten years ago, Microsoft had never paid dividends, but it was one of the best performing stocks in history. Investors knew the value of the business and that they could receive dividends later. However, the dividend discount model would have been a futile way of trying to value stocks.
The dividend discount model is a logical and rational attempt to approach the value of a company’s shares. In a simulated world, investing in a stock based solely on the value of its future dividends would be a perfect system.
Unfortunately, this is not always a reliable indicator in the real world. Investors are often irrational and variables are difficult to predict. These are challenges that all evaluation models face. Even if variables such as future dividends could be predicted with precision, it would be impossible to know the true value of a stock in the market. However, investors should at least try to estimate the value of a stock before investing in order to make an informed decision.
Did you use the discounted dividend model to value a stock? What were the advantages and disadvantages based on your own personal experiences?