11.2 Dividend Discount Models (DDMs)
3 min read•june 18, 2024
Discount Models (DDMs) are essential tools for estimating a stock's based on future payments. These models help investors determine if a stock is overvalued or undervalued by comparing its current market price to the calculated of expected dividends.
DDMs come in various forms, including the , two-stage model, and three-stage model. Each type has its strengths and weaknesses, with factors like dividend growth rates and required returns significantly impacting valuations. Understanding these models is crucial for making informed investment decisions.
Dividend Discount Models (DDMs)
Application of dividend discount models
Top images from around the web for Application of dividend discount models
Section 5.1 Question 2 – Math FAQ View original
Is this image relevant?
Present Value Models – Financial Management for Small Businesses: Financial Statements & Present ... View original
Is this image relevant?
AlterEvo Ltd: ISO 55001 Asset Management as a tool for Value Investing View original
Is this image relevant?
Section 5.1 Question 2 – Math FAQ View original
Is this image relevant?
Present Value Models – Financial Management for Small Businesses: Financial Statements & Present ... View original
Is this image relevant?
1 of 3
Top images from around the web for Application of dividend discount models
Section 5.1 Question 2 – Math FAQ View original
Is this image relevant?
Present Value Models – Financial Management for Small Businesses: Financial Statements & Present ... View original
Is this image relevant?
AlterEvo Ltd: ISO 55001 Asset Management as a tool for Value Investing View original
Is this image relevant?
Section 5.1 Question 2 – Math FAQ View original
Is this image relevant?
Present Value Models – Financial Management for Small Businesses: Financial Statements & Present ... View original
Is this image relevant?
1 of 3
- Estimate of a stock based on present value of expected future dividends
- Intrinsic value represents fundamental value of a stock based on cash flows (dividends)
- DDMs assume stock value equals sum of present values of all future dividend payments
- Steps to apply a DDM:
- Estimate expected future dividends per share
- Determine () based on stock's risk
- Calculate present value of each future dividend using
- Sum present values of all future dividends to obtain intrinsic value of stock
Constant growth model and assumptions
- Constant growth DDM () assumes company's dividends grow at constant rate indefinitely
- Model represented by formula:
- : current stock price
- : expected dividend per share in next period
- : (discount rate)
- : constant of dividends
- Model represented by formula:
- Key assumptions of constant growth DDM:
- Dividends grow at constant rate forever
- Required rate of return greater than dividend ()
- Company has stable dividend policy and expected to continue paying dividends (Coca-Cola, Johnson & Johnson)
- Consistent over time
Strengths vs weaknesses of models
- Strengths of DDMs:
- Provide straightforward way to estimate intrinsic value of stock based on expected cash flows
- Can compare relative attractiveness of different dividend-paying stocks (utilities, REITs)
- Constant growth DDM simple to use and requires few inputs
- Weaknesses of DDMs:
- Rely heavily on accuracy of dividend growth rate estimates, which can be difficult to predict
- May not be suitable for companies that do not pay dividends or have inconsistent policies (growth stocks)
- Constant growth DDM assumes single, constant growth rate forever, which may not be realistic
- DDMs do not account for non-dividend sources of value (retained earnings, potential M&A)
Stock price calculation methods
- Two-stage DDM:
- Assumes company will experience high dividend growth for limited period, followed by lower, stable growth rate
- Model represented by formula:
- : current stock price
- : expected dividend per share in year
- : required rate of return (discount rate)
- : number of years of high growth
- : of stock at end of high growth period, calculated using constant growth DDM
- :
- Assumes company will experience high growth, followed by transition period of declining growth, then final period of stable growth
- Model is extension of two-stage DDM, with additional stage for transition period (Microsoft, Apple)
Impact of variables on valuations
- Dividend growth rate:
- Increase in dividend growth rate leads to higher stock , all else equal
- Decrease in dividend growth rate leads to lower stock valuation
- Required rate of return (discount rate):
- Increase in required rate of return leads to lower stock valuation, all else equal
- Future dividends discounted at higher rate, resulting in lower present values
- Decrease in required rate of return leads to higher stock valuation
- Increase in required rate of return leads to lower stock valuation, all else equal
- :
- Important to perform by varying growth rates and required returns
- Understand potential range of stock valuations
- Assess impact of estimation errors and changes in market conditions on intrinsic value of stock (recession, interest rate changes)
Key Valuation Concepts
- : Fundamental principle in DDMs, as future dividends are discounted to present value
- : Incorporated into the required rate of return, reflecting additional compensation for stock market risk
- : Ratio of dividends to stock price, used to assess income potential and compare dividend-paying stocks
Key Terms to Review (40)
Amazon: Amazon is a multinational technology and e-commerce company founded by Jeff Bezos in 1994. It is one of the largest companies by market capitalization and a key player in various market sectors including cloud computing, digital streaming, and artificial intelligence.
Biogen: Biogen is a biotechnology company that develops therapies for neurological and neurodegenerative diseases. Its performance can be analyzed using financial models like the Dividend Discount Model (DDM) and Discounted Cash Flow (DCF) Model.
Buffett: Buffett refers to Warren Buffett, one of the most successful investors in history and the chairman of Berkshire Hathaway. Known for his value investing strategy, Buffett's principles are often studied in finance courses for their practical insights into stock valuation and market performance.
Cash flow: Cash flow is the net amount of cash being transferred into and out of a business. It represents the company's operating, investing, and financing activities over a specific period.
Cash Flow: Cash flow refers to the net amount of cash and cash-equivalents moving in and out of a business or an individual's possession over a given period of time. It is a crucial measure of financial health and performance, as it reflects the ability to generate and manage the inflow and outflow of cash necessary for operations, investments, and financing activities.
Constant Growth Model: The constant growth model is a dividend discount model used to value a company's stock based on the assumption that the company's dividends will grow at a constant rate in perpetuity. It is a fundamental approach to determining the intrinsic value of a stock by discounting the expected future dividends back to the present value.
Discount rate: The discount rate is the interest rate used to determine the present value of future cash flows. It reflects the time value of money and risk associated with those future cash flows.
Discount Rate: The discount rate is a key concept in finance that represents the interest rate used to determine the present value of future cash flows. It is a crucial factor in various financial analyses and decision-making processes, as it reflects the time value of money and the risk associated with the cash flows being evaluated.
Dividend: A dividend is a payment made by a corporation to its shareholders, usually in the form of cash or additional stock. Dividends are typically derived from the company's profits and are distributed periodically.
Dividend: A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders. Dividends are a key consideration in the Dividend Discount Models (DDMs) and are a defining feature of preferred stock.
Dividend Discount Model: The dividend discount model (DDM) is a method for valuing the price of a stock by using the predicted dividends and discounting them back to the present value. It is based on the premise that the intrinsic value of a stock is the present value of all expected future dividend payments.
Dividend discount model (DDM): The Dividend Discount Model (DDM) is a method used to value a stock by discounting predicted future dividend payments to their present value. This model assumes that dividends are the primary source of a stock's value.
Dividend Payout Ratio: The dividend payout ratio is a financial metric that measures the percentage of a company's net income that is distributed to shareholders in the form of dividends. It represents the portion of earnings a company pays out as dividends, rather than retaining for reinvestment in the business.
Dividend yield: Dividend yield measures the annual dividend income an investor receives from a stock relative to its current share price. It is expressed as a percentage and helps investors evaluate the income-generating potential of a stock investment.
Dividend Yield: Dividend Yield is a financial ratio that measures the annual dividend paid per share relative to the current market price of the share. It represents the return an investor receives from a company's dividend payments, expressed as a percentage of the stock's price.
Equity Risk Premium: The equity risk premium is the additional return that investors expect to receive for holding riskier equity investments compared to the return from risk-free assets. It represents the compensation for taking on the higher level of risk associated with investing in the stock market rather than safer investments like government bonds.
Facebook: Facebook is a social media platform that allows users to connect, share content, and communicate with each other. It has grown into one of the largest digital advertising platforms, influencing market trends and corporate valuations.
Google: Google is a multinational technology company specializing in internet-related services and products, including its search engine. In finance, it is often studied as a publicly traded company with its own stock and valuation metrics.
Gordon growth model: The Gordon Growth Model (GGM) is a method used to determine the intrinsic value of a stock based on a series of future dividends that are expected to grow at a constant rate. It assumes that dividends will continue to increase at a stable growth rate indefinitely.
Gordon Growth Model: The Gordon Growth Model is a valuation method used to estimate the intrinsic value of a stock by discounting the expected future dividends at a rate that accounts for the company's growth rate and cost of capital. It is a fundamental approach to stock valuation that is widely used in finance and investment analysis.
Growth rate: Growth rate is the measure of the increase in value of an investment or a company's earnings over a specific period. It is typically expressed as a percentage.
Growth Rate: The growth rate is a measure of the change in a variable over time, often expressed as a percentage. It is a critical concept in various finance topics, including time value of money, perpetuities, dividend discount models, discounted cash flow analysis, and forecasting cash flow to assess the value of growth.
Intrinsic value: Intrinsic value is the perceived or calculated true worth of a stock, based on future earnings or dividends. It is often used by investors to determine if a stock is overvalued or undervalued compared to its market price.
Intrinsic Value: Intrinsic value refers to the inherent worth or true value of an asset, security, or investment, independent of its market price. It represents the fundamental or underlying value of an investment, calculated based on an analysis of its financial and operational characteristics.
John Burr Williams: John Burr Williams was an American economist and finance theorist who developed the dividend discount model (DDM), a fundamental approach to valuing stocks based on the present value of their expected future dividends.
Multi-Stage Model: The multi-stage model is a valuation technique used in the context of Dividend Discount Models (DDMs) to estimate the intrinsic value of a company's stock. It accounts for the fact that a company's dividend growth rate may change over time, often transitioning from a high initial growth rate to a lower, more stable long-term growth rate.
Myron J. Gordon: Myron J. Gordon was a renowned American economist who made significant contributions to the field of finance, particularly in the development of the Dividend Discount Model (DDM). His work on dividend policy and its impact on stock valuation has been widely recognized and is a fundamental concept in the study of corporate finance.
Perpetuity: A perpetuity is a financial instrument that provides infinite periodic payments with no end date. The value of a perpetuity is calculated by dividing the periodic payment by the discount rate.
Present Value: Present value is a fundamental concept in finance that refers to the current worth of a future sum of money or stream of cash flows, discounted at an appropriate rate of interest. It is a crucial tool for evaluating the time value of money and making informed financial decisions across various topics in finance.
Required rate of return: Required rate of return is the minimum annual percentage earned by an investment that will induce individuals or companies to put money into a particular security or project. It accounts for the risk-free rate plus a risk premium.
Required Rate of Return: The required rate of return is the minimum rate of return an investor demands in order to make an investment. It represents the opportunity cost of the capital being invested and is a crucial factor in various financial decisions and analyses.
Required return: Required return is the minimum annual percentage earned by an investment that will induce individuals or companies to put money into a particular security or project. It is a critical component in stock valuation and investment decision-making processes.
Sensitivity analysis: Sensitivity analysis examines how the variation in input variables affects outcomes in a financial model. It helps identify which variables have the most significant impact on cash flow and growth projections.
Sensitivity Analysis: Sensitivity analysis is a technique used to determine how the output or outcome of a financial model or decision-making process is affected by changes in the values of the input variables or assumptions. It allows decision-makers to understand the impact of uncertainty and identify the key drivers that influence the final result.
Terminal Value: The terminal value, also known as the continuing value, represents the estimated value of a business or investment at the end of a forecast period in a discounted cash flow (DCF) analysis. It is the present value of all future cash flows beyond the explicit forecast period, assuming the business continues to operate indefinitely.
Three-Stage DDM: The three-stage dividend discount model (three-stage DDM) is a variation of the dividend discount model (DDM) used to value a company's stock. It incorporates three distinct stages of dividend growth to more accurately reflect the company's expected future dividend payments and provide a more realistic valuation.
Time Value of Money: The time value of money is a fundamental concept in finance that recognizes the difference in value between a sum of money available today and the same sum available at a future point in time. It is based on the principle that money available at the present time is worth more than the identical sum in the future due to its potential to earn interest or be invested to generate a return.
Time value of money (TVM): Time Value of Money (TVM) is the concept that money available now is worth more than the same amount in the future due to its potential earning capacity. This principle underlines why receiving money today is preferable to receiving it later.
Two-Stage Dividend Discount Model (Two-Stage DDM): The two-stage dividend discount model (Two-Stage DDM) is a valuation method used to estimate the intrinsic value of a company's stock by projecting the company's future dividend payments. It assumes that a company's dividends will grow at one rate for an initial period, and then transition to a different, typically lower, growth rate in perpetuity.
Valuation: Valuation is the process of determining the economic value or worth of an asset, such as a company, property, or financial instrument. It is a crucial concept in finance that is used to assess the intrinsic value of an investment and make informed decisions about its acquisition, management, or sale.