6.2 Dividend Discount Models

Dividend discount models help investors estimate a stock's true value by calculating the present value of future dividends. These models assume a stock's worth equals all future dividend payments discounted to today, helping determine if it's undervalued or overvalued compared to its market price.

The constant growth model assumes dividends grow at a steady rate forever, while multi-stage models account for different growth phases. Though useful, these models have limitations, like only applying to dividend-paying stocks and relying on accurate future estimates.

Dividend Discount Models

Purpose of dividend discount models

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• Estimate intrinsic value of a stock based on present value of expected future dividends
  • Intrinsic value is true value based on fundamental analysis (company's financial health, growth prospects)
  • Assumes stock value equals sum of all future dividend payments discounted to present (time value of money)
• Determine if stock is undervalued, overvalued, or fairly valued compared to current market price
  • Undervalued: intrinsic value higher than market price, may be good investment opportunity (buy low)
  • Overvalued: intrinsic value lower than market price, may not be good investment (sell high)
• Help investors make informed decisions about buying, holding, or selling a stock based on its fundamental value

Application of constant growth model

• Constant growth dividend discount model (Gordon Growth Model) assumes company's dividends grow at constant rate indefinitely
• Formula: $P_0 = \frac{D_1}{r - g}$
  • $P_0$: present value of stock (intrinsic value)
  • $D_1$: expected dividend per share next period
  • $r$: required rate of return (discount rate)
  • $g$: constant growth rate of dividends
• Steps to apply constant growth model:
  1. Estimate expected dividend per share for next period ($D_1$) based on company's dividend history and future outlook
  2. Determine required rate of return ($r$) considering investor's risk preferences and market conditions (risk-free rate, equity risk premium)
  3. Estimate constant growth rate of dividends ($g$) using company's historical dividend growth and future expectations (sustainable growth rate)
  4. Plug values into formula to calculate intrinsic value of stock ($P_0$)
  5. Compare intrinsic value to current market price to assess if stock is undervalued, overvalued, or fairly valued

Multi-stage model for stock valuation

• Multi-stage dividend discount model used when company's dividends expected to grow at different rates over different periods
• Two-stage model assumes:
  • Initial period of high dividend growth (supernormal growth)
  • Subsequent period of stable, constant dividend growth (steady-state growth)
• Formula for two-stage model: $P_0 = \sum_{t=1}^n \frac{D_t}{(1+r)^t} + \frac{P_n}{(1+r)^n}$
  • $P_0$: present value of stock (intrinsic value)
  • $D_t$: expected dividend per share in year $t$
  • $r$: required rate of return (discount rate)
  • $n$: number of years in supernormal growth period
  • $P_n$: terminal value of stock at end of supernormal growth period, calculated using constant growth model: $P_n = \frac{D_{n+1}}{r - g}$
• Steps to apply multi-stage model:
  1. Estimate expected dividends per share for each year during supernormal growth period based on company's growth prospects
  2. Determine required rate of return ($r$) and length of supernormal growth period ($n$) considering company's competitive advantages and industry lifecycle
  3. Estimate constant growth rate ($g$) for stable growth period using long-term economic growth and inflation expectations
  4. Calculate terminal value ($P_n$) using constant growth model
  5. Discount expected dividends and terminal value to present to determine intrinsic value ($P_0$)

Limitations of dividend discount models

• Dividends only source of value: assumes only cash flows investors receive are dividends, ignores potential capital gains from selling stock
• Constant dividend growth: assumes dividends grow at constant rate forever, may not be realistic for many companies (business cycles, competition)
• Accurate estimation of inputs: relies on accurate estimates of future dividends, required rate of return, and growth rates, which can be challenging to predict (uncertainty, market volatility)
• Sensitivity to inputs: intrinsic value highly sensitive to changes in input variables, particularly required rate of return and growth rates (small changes can lead to large differences in valuation)
• Applicable only to dividend-paying stocks: can only be used to value stocks that pay dividends, limiting usefulness for non-dividend-paying companies (growth stocks, startups)
• Use in conjunction with other valuation methods (discounted cash flow, relative valuation) and consider limitations and assumptions when making investment decisions