Everyone should intuitively understand the appeal of buying a dollar for fifty cents, but how does one actually go about figuring out what is worth a dollar and what is worth fifty cents?
There are a number of valuation frameworks available to investors, not all of which are applicable to all situations. Today, we are going to discuss the dividend discount model and what it can tell us about the difference between different sectors, as well as its uses and its limitations.
What is it?
The core thesis behind the dividend discount model is that the present value of a company can be estimated from the sum of all future dividend payments, after the application of an appropriate discount rate. It is calculated by taking expected dividends per share (D) and dividing that figure by the cost of capital equity (r), then subtracting the dividend growth rate (g), resulting in the following formula:
Fair value = D/r-g
The cost of equity is the rate the shareholders require to compensate them for the risk that they undertake by investing in a company. The cost of equity is assumed to be constant through time, so if the dividend growth rate is high, then the model produces a higher valuation, all other things being equal.
The dividend discount model has the advantage of being quite easy to apply, even by investors who are not particularly mathematically inclined.
The uses and misuses of the dividend discount model
You may be asking yourself, "that's all well and good, but what happens if a stock doesn't pay a dividend?" And that's a very valid question - in fact, the percentage of publicly listed companies that pay a dividend has steadily declined over the last few decades. Some of the largest businesses in the world don't pay dividends - Amazon (AMZN, Financial) and Facebook (FB, Financial) being just two examples.
A full explanation for why this secular decline has occurred is beyond the scope of this article, but it has to do with the fact that stock buybacks have replaced dividends as the preferred way to return capital to shareholders, for both tax reasons and executive compensation reasons.
Clearly, the dividend discount model is not very applicable to the technology sector. On the other hand, it is very useful for analyzing companies in sectors like utilities, energy, consumer staples and real estate. This is especially true for real estate investment trusts (REITs), which are legally mandated to pay out at least 90% of their income to shareholders via dividends.
If you are primarily an income investor, then this is the model for you. If not, then don't worry about it. We will be covering other valuation frameworks such as the free cash flow model in future articles.
Disclosure: The author owns no stocks mentioned.
Read more here:
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- John Neff's Investment Philosophy
- Key Takeaways From Fed Chair Jerome Powell's Speech
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