Investors use the dividend discount model (DDM) to evaluate a stock. This model uses a company’s dividend rate to find the estimated fair value and stock price.
If you're a value investor who appreciates fundamental analysis, DDM could be a useful tool. Here’s a closer look at the dividend discount model and how you can use it in your investment strategy.
The Short Version
- You can use the DDM formula to assess a company's value and evaluate its stock price.
- You have to do your research on the company to find out its present and past dividends, and then plug your numbers into a simple formula.
- The DDM is just one tool of fundamental analysis. Others include the Gordon growth model and the competitor multiple analysis.
What Is the Dividend Discount Model?
The DDM is a financial model used to estimate the value of a company and its stock price. It's best used with other fundamental analyses, such as a discounted cash flow analysis and competitor ratio comparisons. As the name implies, the dividend discount model focuses solely on a company’s dividends to determine the company’s intrinsic value.
With this model, your primary inputs are the stock’s expected dividend per share, cost of capital, and expected dividend growth rate. The model assigns companies with a high dividend and strong dividend growth rate a high value and deems companies with no dividends as worthless.
The Dividend Discount Model Formula
The dividend discount model is based on this formula:
Value of stock = Expected dividend in one year / (Cost of capital – Annual growth rate)
That’s sometimes simplified to:
Stock price = D / ( r – g )
D = Expected dividend per share
r = Required rate of return for investors or cost of capital rate for the company
g = Expected perpetual annual dividend growth rate
Here’s a breakdown of what the formula does:
- D is the company’s dividend payment. Whether that’s a few cents per share or many dollars per share, you should enter the expected dividend payment one year from now to estimate the stock price.
- Required rate of return (r) or cost of capital. The required rate of return is up to the investor. Compare the stock to your other investments to pick an appropriate number. Alternatively, you can estimate the business’s cost of capital using its current bond rate of return, if available. In either case, this is an assessment of the company’s future risk.
- The expected annual growth rate (g) for dividends is another assumption. If available, you can look at the company’s dividend growth history to estimate the growth rate. You can also use your company and industry knowledge to calculate rates.
This model requires several assumptions, which can dramatically change the results of your analysis. That’s why it’s essential to be thoughtful about your assumptions and calculate them with care.
An Example Using the Dividend Discount Model
Let’s use the example of a well-known company with a long history of dividends to better understand how the dividend discount model works. 3M is a dividend aristocrat – a company that has increased its dividends for at least 25 consecutive years. This makes it a prime candidate for the DDM.
3M Company Stock Analysis: Dividend Discount Model
3M is a large, steady business with a 4.14% dividend rate and a stock price of $143.93 per share. Its stock currently pays a $1.49 quarterly dividend. The current bond yield to maturity for 3M is 6.375%, with a five-year average of increasing dividends by 0.64%.
That’s all we need to estimate the future stock price. Let’s plug the numbers into the formula:
Stock Price = Expected dividend per share / ( Cost of capital – Dividend growth rate)
= (1.49 (quarterly dividend) x 4 (number of quarters) x 1.0064 (annual growth rate) / (6.375% – 0.64%)
= $5.998 / 0.05735
3M Stock Price = $104.59
As you can see with the math above, the estimated value of a share of 3M, based solely on dividends, is $104.59. Compared to the $143.93 stock price, we would say that 3M is overvalued and not currently a good buy.
However, it’s also important to consider other financial factors when conducting a stock analysis. Your stock brokerage and other large financial data websites are a good source of data when looking for dividend rates and the company’s cost of capital.
Why Would Investors Use the DDM?
If you have a diversified portfolio that’s focused on generating cash flow, the dividend discount model can help you make educated long-term investment decisions. And some active traders use the DDM as part of their personal method of deciding if a stock is overvalued or undervalued. When used correctly, the DDM is a key tool for determining which stocks deserve a spot in your portfolio.
Other Dividend Models to Value a Stock
The DDM relies on a very narrow set of data to calculate the stock’s estimated value. The shortcomings of the DDM may lead you to use an alternative.
The Gordon growth model (GGM) is a popular alternative to the dividend discount model. It takes an extended look at the company’s dividend growth rate and requires you to make assumptions about perpetual dividend growth.
Also, it’s never a bad idea to combine several analysis methods to create a weighted stock price estimate. For example, you could use a discounted cash flow model for 50% of the stock price, competitor multiple analysis for 30%, and the dividend discount model for the final 20%.
Professional investors use complex models, which often include a version of the dividend discount model, to estimate stock prices.
The dividend discount model doesn’t require calculus or other advanced math. It requires high school algebra, a good understanding of the underlying company’s financial situation, and a reasonable estimate of future dividends. With these tools in your investor arsenal, you’re in the best position to pick winning stocks for years to come.