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Dave Ahern
Dave Ahern
Articles (7)  | Author's Website |

Dividend Discount Model: A Simple 3-Step Guide to Valuation

With 3 inputs you can find a value quickly and easily

In our quest to find the intrinsic value of stocks in which we are interested in investing, we have looked at several different types of formulas to help us determine that value. We haven’t considered the role that dividends play in these valuations, and as dividend investors, this is an important fact to factor in. Today we will discuss the dividend discount model to find the intrinsic value of dividend paying stocks.

Dividends are such an important variable to building our wealth, it is in our best interests to continue to add to our toolbox the different methods of calculating intrinsic value. The dividend discount model is simplicity itself and requires only three inputs to determine the value of a stock.

As we continue to strive to find the fair value of any stock that we wish to purchase, it is important to remember that the calculations that we do should never replace other methods of investigation, such as reading the 10-k, looking into other metrics, and doing our research.

In our efforts to narrow down our investing processes and learn more about different formulas to help us find intrinsic value, it is important to remember that we should try not to go down the rabbit hole in search of minutiae. A thought from Warren Buffett (Trades, Portfolio) on intrinsic value.

"It's better to be approximately right than precisely wrong."

That being said we should strive to be as accurate as we can, to help narrow down our errors in finding intrinsic value.

Dividend discount model definition

So what is a dividend discount model?

The dividend discount model (DDM) is a procedure for valuing the price of a stock by using the predicted dividends and discounting them back to the present value. If the value obtained from the DDM is higher than what the shares are currently trading at, then the stock is undervalued.

One thing to keep in mind when utilizing this formula is the fact that it won’t work for a company that doesn’t pay a dividend. So, companies like Tesla (NASDAQ:TSLA), Netflix (NASDAQ:NFLX), Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN) and Alphabet (NASDAQ:GOOG)(NASDAQ:GOOGL) wouldn’t work with this formula.

Dividend discount model formula

This formula is as follows:

Fair value = next year’s expected dividend/discount rate – growth rate

The formula is calculated as follows. It is next year’s expected dividend divided by an appropriate discount rate subtracted from the expected growth rate.

Or: P = D / r – g

This requires three inputs to calculate the formula

  1. One-year forward dividend.
  2. Growth rate.
  3. Discount rate.

Here is how the dividend discount model works. The model works off the idea that the fair value of an asset is the sum of its future cash flows discounted back to fair value with an appropriate discount rate.

Dividends are future cash flows for investors.

This particular model is also known as the Gordon Growth model, and it was created by Myron Gordon and Eli Shapiro at the University of Toronto in 1956.

Today we will use the Gordon Growth model to calculate the intrinsic value of our examples. I have chosen to use this formula as it is a little easier to calculate, and we can use it for our more stable, mature companies.

For our first example, I will use Coca-Cola (NYSE:KO) as it is, to me, a very stable, mature company and should be a fine example of how this formula could work. Remember that we are trying to be approximately correct.

First input

One-year forward dividend payment

To calculate this number we will need to gather some information. I am going to use gurufocus.com to gather what I need to calculate this payment.

What we will need:

  1. Dividend payout ratio for 2016 = 96%.
  2. Return on equity 2016 = 8.95%.
  3. Dividends per share 2016 = $1.40.

Now that we have these numbers we can calculate the growth of the dividend payment for next year.

Expected growth rate = (1 – payout ratio) return on equity

Expected growth rate = (1 - .96) .0895.

Expected growth rate = 0.54%.

Once that number is calculated we can take last year's dividend and calculate next year’s expected dividend payment.

One-year forward dividend payment = dividends per share (1 + growth rate)

One-year forward dividend payment = 1.40 (1 + 0.0054).

One-year forward dividend payment = $1.41

Second input

Discount rate

To calculate the discount rate we are going to need to gather a formula for the discount rate which will be:

Discount rate = Risk-free rate + beta (risk premium)

To make this formula work we need to find some numbers to plug into the formula.

  1. Beta for Coca-Cola = .553.
  2. Risk-free rate = 2.30%.
  3. Risk premium = 5.69%.

To find the Beta for Coke we can use Damodaran.com, which is a website run by Aswath Damodaran, who I’ve mentioned before. He is a professor of finance at NYU Stern and is a brilliant guy and a fantastic teacher.

I use his calculator available on his site to calculate all my betas. You just need a ticker symbol for your company and a date range you would like it to calculate it for you.

I am going to use Coke and find a beta for a 10-year period to try to find the most consistent number of our calculations.

Next, we need to find the risk-free rate for our formula. The risk-free rate is the theoretical rate of return of an investment with no risk. Wouldn’t that be nice? I use the 10-year Treasury Bill rate for my risk-free rate. This would be the absolute return I would expect if there was no growth for my company.

And finally, we get to the risk premium for our formula. This is fairly easy to acquire as well. Just follow the link here. The risk premium is the difference between the expected market return on a market portfolio and the risk-free rate.

Again we are going to use the data that Professor Damodaran provides for all of us, free of charge.

Now that we have all the numbers for our formula, let’s go ahead and calculate our discount rate.

Discount rate = risk free rate + beta (risk premium)

Discount rate = .023 + .553 (.0569).

Discount rate = 5.44%

Third input

Growth rate

We calculated our growth rate when we were looking to find the growth rate for our dividend. So this number has already been calculated for Coke.

Putting it all together

Now to solve for our dividend discount model we need to plug all the numbers into our formula and calculate the intrinsic value of Coke via the dividend discount model.

Value = one-year dividend rate / discount rate – growth rate

  • One-year dividend rate = $1.40.
  • Discount rate = 5.44%.
  • Growth rate = 0.54%.

Plugging the numbers into the formula.

Value = 1.40 / 0.0544 – 0.0054.

Value = $28.57

Based on our calculations with our dividend discount model we come up with an intrinsic value of Coke of $28.57 compared to its current price of $42.95 as of April 12.

This indicates that this company is overvalued at this time and would warrant a further look into why it might be overvalued. As a further indicator of this pricing, I did a quick discounted cash flow calculation and came up with a similar result.

As you do these calculations, I try my hardest to be as conservative as I can to help mitigate any mistakes I make in my calculations.

Finding intrinsic value in any company is an art and the variables can be very sensitive to many different factors. And this sensitivity can add to the fluctuations you get from these formulas.

I noticed as I was doing research for this article that there were many different versions of this formula, but I chose to follow Professor Damodaran’s examples as I have always found his calculations on the more conservative side. To me, this helps us find a margin of safety to protect our investments.

Ready to try a few more?

All right let’s try a REIT, which stands for real estate investment trust, an investment vehicle that invests in many different types of real estates, such as the health care industry, office buildings, malls and residential housing among others.

The dividends of these types of companies are extremely attractive, but they are very sensitive to interest rate fluctuations and market forces.

They are not necessarily my cup of tea, as far as investments go, but by law, they are required to pay out 90% of their earnings as dividends so they make the perfect vehicle for us to practice our new formula.

For our example today let’s use Omega Healthcare Investors (NYSE:OHI). It is a health care REIT with over 900 locations in the U.S. and England. It specializes in senior housing and skilled nursing facilities.

OK, let’s grab some numbers and plug them into our formulas to see what kind of intrinsic value we can calculate.

Numbers

  1. Dividend payout ratio = 99.15%.
  2. Return on equity = 12.94%.
  3. Dividends per share = $2.36.
  4. Earnings per share = $2.38.
  5. Beta = 0.864.
  6. Risk-free rate = 2.30%.
  7. Risk premium = 5.69%.

Formulas

  • Expected growth rate = (1 – payout ratio) return on equity.
  • One-year forward dividend payment = dividends per share (1 + growth rate).
  • Discount rate = risk-free rate + beta (risk premium).
  • Value = One-year dividend rate / discount rate – growth rate

The solution for Omega Healthcare Investors

After plugging all the numbers in and doing the calculations we come up with the number of $33.24, and the market price as of April 12 was $34.11. This indicates that the company is overpriced currently.

This is kind of fun; aren’t you enjoying it? I know I certainly am.

Valuations of the top Dividend Aristocrats

Now that we have gotten our feet wet with the formulas and see how they work, I want to take a look at some Dividend Aristocrats and see how they shape up when using this formula.

The Aristocrats are in a class of mature, developed companies that are going to be paying a pretty consistent dividend as well as having steady growth.

 

Those were interesting results, indicative of the state of the current market conditions and the high valuations of many companies.

I compared our results to the results if I did an intrinsic value via the Benjamin Graham formula, and a discounted cash flow valuation as well, and they were similar in that these companies appeared to be overvalued at this time.

This does not mean that all Dividend Aristocrats are currently overpriced, but it does show that if you choose to invest in the companies at their current prices you are doing so without any margin of safety, which can be a risk.

The ugly of the dividend discount model

This model is by no means perfect, as almost no model is without its challenges. Some of the shortcomings of this model are:

  • The dividend discount model values a stock forever.
  • No business lasts forever.
  • This model gives value to dividends paid 100-plus years from now.
  • Is only useful for dividend paying stocks.
  • Doesn’t take into account changing payout ratios.

Making forecasts for 100-plus years is crazy, I am a big believer in long-term investing, but that is foolish. There are very few companies that have been around for that long; nothing is forever.

Think about our recent history. Remember Kodak? At one time they were the king of film, but with the invention of the smartphone and their mobile cameras, suddenly Kodak was a dinosaur because now everyone was a photographer and who needed to develop film anymore?

This to me illustrates a major weakness of this model. True, it can be of use to get you in the ballpark, but if you want to be more precise we need to find some modifications to this model.

Next week, we will look at the two-stage dividend discount model which showcases more modifications to this model and adds the ability to adapt the growth stages of a company, which can make our numbers a little more precise.

Final thoughts

The dividend discount model has some serious flaws, which we outlined above. The fact is so does every other valuation metric, but the degree to which they are flawed depends on the inputs that we put into them.

These models should never be the final answer for our investment decisions; they are too used as tools to help us find a margin of safety in case our decisions or our inputs are flawed.

A dividend discount model is a useful tool in assessing the value of dividend-paying stocks and helping us assess our assumptions of that particular company. It also provides us with a different way to value a company that pays a dividend.

The Gordon Growth model is a fairly simple and convenient way to value a stock but it is extremely sensitive to the inputs for the growth rate. If it is used incorrectly, it can lead to absurd or misleading results because as the growth rate converges on the discount rate, our valuation can go to infinity.

In summary, this dividend discount model works best for companies growing at a stable rate and have well-established dividend-paying policies that they will continue into the future. This is why the Dividend Aristocrats are a perfect vehicle to test this formula with.

Remember that valuation is an art not a science, and there is no perfect way to invest. We use these tools to help us find great companies in which to invest and with a margin of safety, which is critical to our long-term growth of our portfolios.

As always, thank you for taking the time to read this article and I hope you have found it of value to you.

Take care,

Dave

Disclosure: The author has no positions in the stocks mentioned in this article and has no plans to initiate any.

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Comments

JohnKarma
JohnKarma - 1 week ago    Report SPAM

from:

Expected growth rate = (1 – payout ratio) return on equity

Expected growth rate = (1 - .96) .0895.

Expected growth rate = 0.54%.

I don't get 0.54%

Dave Ahern
Dave Ahern - 1 week ago    Report SPAM

Yeah, you are correct. I did the math late at night and made a mistake. Sorry for that. It should be 0.358%. Wish I had a good excuse, but I don't.

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