The dividend discount model is one of the most traditional and conservative methods for valuing an individual stock. A dividend discount model, also known as the Gordon Growth Model, assumes that a stock is equal to the present value of all its future dividend payments.
The beauty of the dividend discount model is in its simplicity and effectiveness on dividend-paying stocks.
How the Dividend Discount Model Works
The dividend discount model incorporates only a few variables:
- Price of the stock.
- Dividends in the next year.
- Cost of capital, or your expected return.
- Growth rate of the dividend stream.
Having three of these four variables allows you to solve for the remaining variable. Most often, one knows the dividends to be paid in the next year, the return desired on an investment, and some idea of a perpetual growth rate for the company’s dividend stream. Having these variables allows you to solve for the value of a single share of stock.
Price = Dividends ÷ (Rate of Return – Dividend Growth Rate)
Here’s an example: A company pays an annual dividend of $1 per share. The dividend is expected to grow at 6% per year. Investors want at least 10% returns on their investments. What should an investor pay for the stock?
Plugging in our variables gives us Price = $1.00 ÷ (1.10 – 1.06). Following through with simple math gives us Price = $25. In essence, this tells us that as long as we pay less than $25 per share and the company increases its dividends at an annual rate of 6% per year, we will earn a 10% return on our investment.
Pros and Cons to Dividend Discount Models
There is no perfect way to value a stock, and the dividend discount model is just one of many ways to value any given stock.
What makes the dividend discount model great:
- Conservatism – The dividend discount model values a company only on what it pays out to investors. It does not directly take into consideration earnings of a company, the cash the company holds, or anything other than the dividend. It assumes that the investor will generate a return from dividends, not appreciation or some pie-in-the-sky buyout at a 200% premium to the current trading price.
- Simplicity – The dividend discount model is one of the easiest ways to value a security. It requires only three inputs, which almost any investor can reasonably determine or forecast. Because of its conservatism, investors who value companies with a dividend discount model have more room for error in the variables they forecast than do investors who use alternative, more finicky projections.
These two advantages lead directly into the model’s disadvantages:
- Selectivity – The dividend discount model is limited in that it can be properly used only with companies that pay a regular dividend, and which are expected to increase their dividend at a constant rate in the future. This severely limits the model to very stable companies like Coca-Cola (KO) or McDonald’s (MCD), which are both known for a long history of fairly regular dividend increases each year.
- Sensitivity – As with all valuation methods, the dividend discount model is only as good as the numbers going into it. Garbage in, garbage out – the model works only as long as the key assumptions in the model prove to be mostly accurate.
As always, this model should be used with a margin of safety in mind. A margin of safety protects investors from faulty assumptions in the model, and about a company’s competitive durability.
Investors who calculate a $50 per-share price for a company may want to buy only when it is 25% undervalued or more, for example, hitting buy at $37.50 per share or less in order to make up for the erroneous inputs in their model. Investing begins with the preservation of capital. Being too safe is much better than being reckless, especially when it comes to our own biases about what we want to believe about the investments we pick for our portfolios.