The Dividend Discount Model: Valuing a Future Income Stream

The Dividend Discount Model (DDM) will help you figure out the value of a business that pays a steady stream of dividend income.

The price you pay for a business is very important because it directly affects your future returns.  The lower the price you pay, the higher your future return... provided of course, that the business you are buying is of high quality!  Click here to find out our selection criteria for dividend paying stocks.

What is The Dividend Discount Model?

The DDM is an equation that calculates the fair value of a dividend paying business based on the idea that it is worth the sum of all future dividend payments brought back (or discounted) to today’s dollars.  So basically, when buying a dividend growth stock, you are buying a growing stream of future income.  The DDM puts a value on that growing stream of income.

Without further a due, here is the equation of the DDM:

STOCK’S ESTIMATED VALUE = NEXT YEAR’S DIVIDEND/REQUIRED RATE OF RETURN – AVERAGE ANNUAL DIVIDEND GROWTH RATE

The Required Rate of Return (RRR)

Now before we dive into an example of the DDM, let’s first nail down the RRR.  This is a very important component so please bear with me!  Plus, you are probably thinking to yourself... “What is that?”  I know I was at first.

To get the RRR we will use the Capital Asset Pricing Model (CAPM) which is commonly used in the finance world and isn’t as complicated as it sounds:

RRR = Real Risk Free Rate (RRFR) + The Stock’s Beta(Expected Market Return – RRFR)

The RRFR is the guaranteed interest rate that you can get on your money without taking any risk... so basically the current 10 year T-Bill or government bond.  This rate is forever changing based on the state of the economy so you will have to check when doing your calculation. 

Next, the expected return of the overall market can be estimated by using the historical long term average annual returns of the stock market. The grand daddy of stock market indexes is the S&P 500 index which tracks the performance of the 500 leading U.S. large cap companies.  The Compounded Annual Growth Rate of the S&P 500 between January 1, 1957 and December 31, 2012 is 9.73% so we will use this number.

The last component we need is the stock’s beta.  This is basically a number that represents a company’s market risk.  It is determined by how volatile the stock’s daily price movements are as compared to the overall market index. If the stock’s price fluctuates more wildly that the market index, then its beta will be greater than 1.  If the market index is more volatile than the stock’s price, its beta will be less than 1.  A stock’s beta can be found readily at websites such as Yahoo! Finance.

Why Beta? A company’s risk to an investor is a combination of its business risk (how vulnerable are they to competitors?), financial risk (does it have too much debt?), exchange rate risk (will the currency it trades in depreciate?) and country risk (is the country politically stable?).  In the finance world, beta is thought to represent these risks fairly accurately.

So to quickly summarize the Required Rate of Return, it is basically determined based on the fact that as an investor, you should demand a return that compensates you for the risk you are taking above the risk free rate.

Back to the Dividend Discount Model... 

Ok now that you are familiar with the RRR, let’s move on to an example.

Let’s say you have been following XYZ Financial and you find that they have a strong balance sheet, good management, and a history of steady earnings and dividend growth.  You like the company and its future prospects so you decide to invest some of your hard-earned money into purchasing some of their shares.  Before you buy any of the shares, however, you want to know roughly what their value is to make sure you aren’t overpaying. 

The current market price of XYZ is $48.50 a share and they are paying out $2.52 annually in dividends.  They have historically increased their earnings and dividends by an average of 10% a year in the past.  Based on management’s earnings growth targets and industry consensus, you decide that conservatively, the company should grow dividends by an average of 8% annually in the future.  You also find at a popular financial website that XYZ’s beta is 1.17.

You look into the current rate of a 10 year Treasury Bill and it is 3%, which you could get without taking any risk.  The Compounded Annual Growth Rate of the S&P 500 between January 1, 1957 and December 31, 2012 is 9.73% so you expect that you can achieve this return over time by investing in the overall market.

So let’s first calculate the Required Rate of Return using the CAPM equation as shown above...

RRR = 0.03 + 1.17(0.0973 – 0.03) = 0.1087 or 10.87%

Now that you know your required return, let’s figure out what XYZ’s estimated value is using the Dividend Discount Model...

Based on your estimated dividend growth, you figure XYZ will pay out $2.72 a share next year ($2.52(1.08)).

So XYZ’s Estimated Value = 2.72/.1087 – 0.08 = $94.77

Based on the current market price of $48.50, XYZ appears to be a good buy because the DDM is estimating its value at $94.77!

The DDM works well for slower growing companies with very predictable earnings and dividend growth, and a relatively high yield.  Unfortunately, it does not work very well with faster growing companies where dividend growth matches or outpaces the required return.

Click here to find out how we also use dividend yield to make sure we aren’t paying too much for the best dividend stocks.

That wraps up our lesson on the Dividend Discount Model... excellent job!

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