RESEARCH Dividend Discount Model

By John Del Vecchio (TMF Fuz)

April 6, 2000
The dividend discount model can be a worthwhile tool for equity valuation. Financial theory
states that the value of a stock is the worth all of the future cash flows expected to be generated
by the firm discounted by an appropriate risk-adjusted rate. We can use dividends as a measure
of the cash flows returned to the shareholder.
There are several dividend discount models (DDMs), and this article will address two of the
more basic forms of the DDM -- the stable model and the two-stage model. As an illustration,
both models will be used to value the stock of Caterpillar (NYSE: CAT).
Inputs Into the DDM
Several inputs are required to estimate the value of an equity using the DDM.
DPS(1) = Dividends expected to be received in one year.
Ks = The required rate of return for the investment. The required rate of return can be
estimated using the following formula: Risk-free rate + (Market risk premium) * Beta
The rate on t-bills can be used to determine the risk-free rate. The market risk premium is the
expected return of the market in excess of the risk-free rate. Beta can be thought of as the
sensitivity of the stock compared with the market.
g = Growth rate in dividends
Stable Model
Value of stock = DPS(1) / Ks-g
Caveats: The stable model is best suited for firms experiencing long-term stable growth.
Generally, stable firms are assumed to grow at the rate equal to the long-term nominal growth
rate of the economy (inflation plus real growth in GDP). In other words, the model assumes it is
impossible to grow at 30% forever, otherwise, the company would be larger than the economy.
Investment Theory -1- Topic 7 Handout
If the growth rate of the firm exceeded the required rate of return, you could not calculate the
value of the stock. This is because if g>Ks, the result would be negative, and stocks do not have
a negative value.
Another caveat is that models are often very sensitive to the assumptions made regarding growth
rates, time frame, or the required rate of return.
Finally, the dividend discount model generally understates the intrinsic value of the firm.
Important considerations such as the value of patents, brand name, and other intangible assets
should be used in conjunction with the DDM to assess the value of a firm's equity. These
intangibles should be added to the result of a DDM calculation to arrive at a more appropriate
valuation.
An Example:
DPS = Caterpillar has a dividend of $1.30
Ks = 6% + (6.8%) * 1.0 = 12.8% (we use a Beta of 1 because it should be the same as the market
during the stable growth period)
g = Because the stable model assumes a growth rate equal to the long-term nominal growth of
the economy, we will use a growth rate of 6% (3% inflation + 3% GDP growth).
V = 1.30 * (1.06) / (.1280-.06)
V = $20.26
Caterpillar's recent price of $38.63 per share shows that the dividend discount model suggests
that Caterpillar is overvalued. However, Caterpillar for example, has a strong brand name, and
customers will pay a premium price for its products. This is a good example of how the dividend
discount model may understate the intrinsic value of the equity. Adjustments should be made to
estimate the value of brand name or other value-enhancing traits that a company may possess.
The Two-Stage Model
The two-stage model attempts to cross the chasm from theory to reality. The two-stage model
assumes that the company will experience a period of high-growth followed by a decline to a
stable growth period.
Caveats: The first issue to deal with when using the two-stage model is to estimate how long the
high growth period should last. Should it be 5 years, 10 years, or maybe longer?
Investment Theory -2- Topic 7 Handout
The next caveat is that the model makes an abrupt transition from high growth to low growth. In
other words, the model assumes that the firm may be growing at 30% for five years only to then
grow at 6% (stable growth) until eternity. Is this realistic? Probably not. Most firms experience a
gradual decline in growth rates as their business matures (hence, using a three-stage dividend
discount model may be more appropriate, yikes!).
Finally, just like the stable growth model, the two-stage dividend discount model is very
sensitive to the inputs used to determine the value of the equity.
An Example:
High-growth phase (assuming five years for illustration purposes):
DPS = $1.30
Ks = 6% + (6.8%) * 0.94 = 12.39%
g = (1 - Payout Ratio ) * ROE = .506 * .1781 = 9%
DPS(1) = $1.30 * 1.09 = $1.42
DPS(2) = $1.42 * 1.09 = $1.54
DPS(3) = $1.54 * 1.09 = $1.68
DPS(4) = $1.68 * 1.09 = $1.84
DPS(5) = $1.84 * 1.09 = $2.00
Now, we must discount the dividends by the appropriate rate to determine their present value.
$1.42 / (1.1239) = $1.26
$1.54 / (1.1239)
2
= $1.22
$1.68 / (1.1239)
3
= $1.19
$1.84 / (1.1239)
4
= $1.15
$2.00 / (1.1239)
5
= $1.12
We add up the present value for the dividends during the high-growth stage and get $5.94.
Next, we value the stable growth period:
DPS = $2.00 (1.06) = $2.12
Ks = 12.8%
g = 6%
Investment Theory -3- Topic 7 Handout
$2.12 / (.128-0.06) = $31.18
Next, we must calculate the present value of the dividends.
$31.18 / (1.1239)5 = $17.39
When calculating the present value of the dividends of the stable growth period, we use the same
required rate of return as the high-growth phase and raise it to the fifth power for a five-year
example like the one above.
Adding the two values, we get: $17.39 + $5.94 = $23.33
Again, our result is quite a bit lower than the current market price.
Important Note
Notice that most of the "value" of the equity is derived from the stable growth period (17.39 /
23.33 = 74.5%). This is an indication that the market views the value of equity from a long-term,
not short-term perspective.
What if the Stock Does Not Pay Dividends?
The DDM can still be used to value stocks that do not pay dividends. The analyst must make
assumptions about what the dividend would be if the firm did pay dividends. Starting with free
cash flow and estimating the dividend pay-out ratio based on comparable firms in the
marketplace or industry can yield reasonable results for a non-dividend paying company.
What Is the Usefulness of the DDM?
It depends on how you apply the model. Since the model is highly sensitive to the assumptions
made about growth rates and discount rates, performing a sensitivity analysis would be
appropriate. Sensitivity analysis allows the investor to view how different assumptions change
the valuation using the dividend discount model. Secondly, the dividend discount model is a
good starting point to begin thinking about the valuation of an equity, but it is not the Holy Grail.
Intel (Nasdaq: INTC) has a substantial percentage of its value explained by intangible assets like
the brainpower of its employees. Using the DDM may result in ridiculously low estimates of
Investment Theory -4- Topic 7 Handout
Intel's value. Finally, the DDM is a good thinking exercise. It forces the investors to begin
thinking about different scenarios in relation to how the market is pricing the stock.
Do Professionals Use the DDM?
Yes. For example, Merrill Lynch (NYSE: MER) uses the DDM model as a component of its
market-beating Alpha Surprise Model. JP Morgan (NYSE: JPM) uses the DDM as an important
input into the valuation and stock selection process. However, the DDM is only one of many
valuation tools used in equity analysis.
The dividend discount model provides an excellent illustration of the difference between theory
and reality. Plenty of assumptions must be made, the transition phases are often unrealistic, and a
firm's intangibles, often a key driver in the growth rate of the company, are absent from the
model. Yet, many analysts still use the DDM as a gauge for valuation. That's fine, just remember
it is a model, after all, so use it carefully.
Source: Dividend and EPS data from Marketguide.
Investment Theory -5- Topic 7 Handout
A dividend discount model is a financial model for valuing the price of a stock by using
predicted dividends and discounting them back to present value. The idea is that if the value
obtained from the DDM is higher than what the shares are currently trading at, then the stock is
undervalued.
This model would typically be a discounted cash flow (DCF) using dividend forecasts over
several stages. And how this model works is as follows :
1. The expected dividends are estimated for the high growth period, using the payout ratio for the
high growth period and the expected growth rate in earnings per share.
2. The expected growth rate is estimated either using fundamentals: Expected growth =
Retention Ratio * Return on Equity. Alternatively, you can input the expected growth rate. At the
end of the high growth phase, the expected terminal price is estimated using dividends per share
one year after the high growth period, using the growth rate in stable growth, the payout ratio in
stable growth and the cost of equity in stable growth.
3. The dividends per share and the terminal price are discounted back to the present at the cost of
equity changes. If your cost of equity in stable growth is different from your cost of equity in
high growth, the cost of equity in the second half of the stable growth period will be adjusted
gradually from the high growth cost of equity to a stable growth cost of equity.
Topic 7: Equity Valuation with Dividend Discount Models and P/E Ratios
BUS 442 Investment Theory and Portfolio Management
Investment Theory -6- Topic 7 Handout
In the previous topic, you learned about the approach commonly adopted to determine the
intrinsic value (or fair market price) of a bond, which is simply the present value of all the cash
flows (i.e. coupon payments and principal) expected from the bond. We will use the same
concept (or approach) to determine the value of a common stock, namely the dividend discount
model. We will also look at another method to determine the value of a common stock, which is
based on its P/E ratio.
Since we are dealing with the valuation of a common stock (i.e. determining the value of a
stock), we need to first clarify some of the terms associated with value before we proceed. There
are three common terms:
(a) Book value
(b) Market value
(c) Intrinsic (or economic) value
1. Relationship Between Market Value and Intrinsic Value
Why do we need to know the difference between a stocks market value and its intrinsic value?
If you remember the discussion we had in Topic 3, using the capital asset pricing model, we can
determine if a stock is underpriced or overpriced by comparing its actual return and its expected
return (according to CAPM). We are using the concept here except we are comparing a stocks
market value and its intrinsic value to determine if it is underpriced or overpriced.
Market value > Intrinsic value Stock is overpriced
Market value = Intrinsic value Stock is correctly priced
Market value < Intrinsic value Stock is underpriced
2. Deriving the Dividend Discount Model
Investment Theory -7- Topic 7 Handout
Just as in the case with a bond, the intrinsic value of a stock is the present value of all the cash
flows expected from the stock. However, it is more difficult to determine a stocks intrinsic value
because the dividend payments are not fixed and its life is infinite (theoretically).
We will derive the model used to determine the value of a stock with a very simple premise: the
stock will be held for an infinite amount of time. In addition, the stock pays dividend once a
year. To simplify our model, it is assumed that the intrinsic value will be the same as the market
value (i.e. V = P) in equilibrium.
To determine the current intrinsic value of the stock, all the cash flows expected from the stock
(i.e. the dividends) will be discounted using the appropriate risk-adjusted interest rate (or return)
k, which can be estimated using CAPM. The intrinsic value of the stock is represented by the
following equation (which is commonly known as the dividend discount model):
( )
( ) ( )

+
+ +
+
+
+

k
D
k
D
k
D
P V
1
....
1
1
2
2 1
0 0
The above model will help determine the intrinsic value of a stock if you planned on holding it
forever. What if you only planned on holding it for 5 years? For 10 years? How is the stock value
then?
Based on the same concept, we know the following is true:
( ) ( ) ( )

+
+ +
+
+
+

k
D
k
D
k
D
P V
1
....
1 1
2
3 2
1 1
( )
( ) ( )

+
+ +
+
+
+

k
D
k
D
k
D
P V
1
....
1
1
2
4 3
2 2
With the above information, we can derive the following:
( ) ( )
( ) ( )
( ) k
P
k
D
k
D
k
D
k
D
k k
D
P
+
+
+

]
]
]
]

+
+
+
+
+ +
+
+

1 1
1
....
1
1 1
1
1
1 1
2
3 2 1
0
Similarly, we can also derive the following:
( )
( )
( )
( )
( )
( )
2
2
2
2 1
3
2 2
2 1
0
) 1 ( 1
1
1
....
1 ) 1 (
1
1
1
k
P
k
D
k
D
k
D
k
D
k k
D
k
D
P
+
+
+
+
+

]
]
]
]

+
+
+ +
+
+
+
+

Investment Theory -8- Topic 7 Handout

As a result, we can derive the following model to determine the intrinsic value of a stock that
will be held for n years:
( )
( ) ( ) ( )
n at time price stock expected of lue present va +
dividends future expected all of lue present va
1 1
....
1
1
2
2 1
0

+
+
+
+ +
+
+
+

n
n
n
n
k
P
k
D
k
D
k
D
P
Refer to In-class Example
1
3. Constant Growth Dividend Discount Model
The dividend discount model (DDM) represented above is a good start for determining the value
of a common stock but it is not very practical to use because an investor will need to estimate the
amount of dividends expected from the stock (and also the expected sales price depending on the
model used).
Investment Theory -9- Topic 7 Handout
Certain assumptions will have to be made in order to make the DDM usable. The most common
assumption adopted is a constant growth rate for the dividends. In other words, dividend
payments are expected to grow at a constant rate forever. We can express all the future dividends
in terms of the upcoming dividend (D
0
) as follow:
0
3
2 3
0
2
1 2
0 1
) 1 ( ) 1 (
) 1 ( ) 1 (
) 1 (
D g D g D
D g D g D
D g D
+ +
+ +
+
We can then substitute the dividend payments expressed above back into the original DDM as
follows:
( )
( ) ( )
( )
( ) ( )
]
]
]

]
]
]
]

,
`

.
|
+
+
+ +
,
`

.
|
+
+
+
+
+

+
+
+ +
+
+
+
+
+

+
+ +
+
+
+

g k
g
D
k
g
k
g
k
g
D
k
g D
k
g D
k
g D
k
D
k
D
k
D
P
1
1
1
...
1
1
1
1
1
) 1 (
....
1
) 1 (
1
) 1 (
1
....
1
1
0
2
0
0
2
2
0 0
2
2 1
0
The advantage of doing so is that we can simplify the formula for the common stocks intrinsic
value as follows:
g k
D
g k
g D
P

1 0
0
) 1 (
The DDM represented by the formula above (i.e. constant growth rate) is known as the constant
growth DDM or the Gordon growth model.
Refer to In-class Example
2
There are a few things that you need to be aware of before using the constant growth DDM to
estimate the value of a common stock.
The model is only suitable for stocks that pay a steady stream of dividends
The model is only suitable for stocks that has a growth rate that is lower than the required
return (i.e. the model is not suitable for valuing growth stock)
Investment Theory -10- Topic 7 Handout
Since the growth rate plays a major role in the constant growth DDM, it is very important that
great care is taken to estimate it. Any small error will greatly impact the estimated value of the
common stock. Why?
How do we estimate the growth rate of the dividend? We will look at three different ways to
estimate the growth rate: (a) using historical dividends, (b) using historical earnings, and
(c) using return on equity (ROE).
(a) Using historical dividends
You need to first identify a period that best represents a companys growth period. Using
the point-to-point estimation method, which is based on the first and last dividend of the
growth period, you can approximate the growth rate of the dividend during that period. You
can use the estimated growth rate as a proxy for the companys expected future dividend
growth rate.
You have to keep in mind that this method focuses solely on the first and last dividend of the
chosen period. If the first and/or the last dividends are significantly different from the rest of
the dividends (i.e. outliers), you will either underestimate or overestimate the dividend
growth rate.
(b) Using historical earnings
Since dividends are derived from a companys earnings, we can estimate the dividends
growth rate based on the earnings growth (using the point-to-point estimation method from
before). This method of estimating the dividends growth rate is feasible if the company
consistently pays out the same percentage of its earnings as dividends. In other words, the
companys payout ratio is constant.
(c) Using return on equity (ROE)
This is also known as the sustainable growth method. It is based on three assumptions: (1)
the company wants to grow as fast as possible; (2) management does not want to (or cannot)
issue any new equity; and (3) the company wants to maintain both its capital structure and
dividend policies. Can you explain the implications of the three assumptions?
Investment Theory -11- Topic 7 Handout
In order to fulfill the above three assumptions, the companys source of equity financing will
come from its retained earnings (i.e. internal financing). As a result, the firms growth rate is
based on the growth rate of its retained earnings. How fast can a companys retained grow?
The following equation shows how the growth rate can be estimated:
ROE
g

) ratio payout 1 (
equity Total
Earnings
) ratio payout 1 (
equity Total
Earnings ) ratio payout 1 (
equity Total
earnings retained
Refer to In-class Example
3
4. Two-Stage Dividend Discount Model
The constant dividend growth model is only suitable for determining the value of stocks of an
established company. Why? The model will only work when: (1) the growth rate is constant and
(2) the growth rate is less than the required return. That means this model is not suitable for a
growth company that generally goes through a period of high growth rate (which is usually
higher than the required return) before settling down to a lower growth rate.
Investment Theory -12- Topic 7 Handout
How do we estimate the value of a stock that has two different growth rates? We can modify the
previous model and change it into a two-stage model. The first stage is considered the abnormal
growth stage, where the company is experiencing a rapid growth (and the growth is higher than
its required return). The second stage is where the company matures and its growth rate has
slowed (and it is below its required return). It is assumed that the company will sustain that
lower growth rate indefinitely.
(a) Abnormal growth stage
Suppose the company goes through the abnormal (or rapid) growth stage for T periods. We
can easily determine the present value of all the dividend payments in the abnormal growth
stage as follows:
( )
( ) ( )
T
T
a
k
D
k
D
k
D
PV
+
+ +
+
+
+

1
....
1
1
2
2 1
However, it is not always easy to estimate all the dividend payments during this period. It is,
therefore, common to approximate the dividend payments based on the estimated abnormal
growth rate (g
a
). It will change the above formula as follows:
( )
( ) ( )
T
T
a a a
a
k
g D
k
g D
k
g D
PV
+
+
+ +
+
+
+
+
+

1
) 1 (
....
1
) 1 (
1
) 1 (
0
2
2
0 0
(b) Constant (or normal) growth stage
In the normal growth stage, the dividends are assumed to grow at a constant rate (i.e. g
n
)
indefinitely. As a result, we can use the constant growth dividend discount model to estimate
the value (i.e. PV
n
) of the stock in time T.
n
T
T n
g k
D
PV

+1
,
Once again, it often time necessary to estimate the D
T+1
based on the prior dividend (i.e. D
T
).
However, since we are already in the normal growth stage, the dividend will now be growing
at the normal rate. We can then rewrite the formula for the value of the stock in the constant
growth stage (in time T) as follows:
n
n T
T n
g k
g D
PV

) 1 (
,
Now we need to determine the present value of the stock at time 0 (i.e. the current period):
) ( ) 1 (
) 1 (
0 ,
n
T
n T
n
g k k
g D
PV
+
+

Investment Theory -13- Topic 7 Handout

(c) Total value of a two-stage growth stock
The value of a two-stage growth stock is simply the sum of its present value in the abnormal
growth stage and the present value in the normal growth stage:
( )
( ) ( ) ) ( ) 1 (
) 1 (
1
) 1 (
....
1
) 1 (
1
) 1 (
0
2
2
0 0
0 , 0 , 0
n
T
n T
T
T
a a a
n a
g k k
g D
k
g D
k
g D
k
g D
PV PV P
+
+
+
+
+
+ +
+
+
+
+
+

+
Refer to In-class Example
4
Refer to In-class Example
5
In the above model and examples, it has been assumed that the required return for the stock is the
same for both the abnormal and constant growth stages. However, investors are very likely to
have different returns for the two stages. Since company generally faces more risks during its
abnormal growth stage, investors will require a higher return during this stage. On the other
hand, the company is maturing during the normal (or constant) growth stage and thus faces
less risk. As a result, investors are also demanding a lower return during this stage.
Refer to In-class Example
6
5. Multi-Stage Dividend Discount Model
A problem associated with the two-stage dividend discount model is that it assumes an
immediate transition from the abnormal (i.e. high) growth stage to the normal (i.e. low) growth
stage. However, this is generally not the case with most companies. There is usually a transition
period when the companys growth rate gradually decline from the higher growth rate to the
lower (and constant) growth rate.
Once you understand the concept behind the two-stage dividend growth model, it can be easily
modified to deal with scenarios where a company faces multi-stage growth periods.
Refer to In-class Example
7
6. Deriving the Price to Earnings (P/E) Ratio
Investment Theory -14- Topic 7 Handout
Another approach to identifying desirable stocks is the use of the P/E ratios (or price-earnings
multiples), which is very common among many investors. What is the P/E ratio? A companys
P/E ratio basically shows how much investors are willing to pay for every $1 of the companys
future earnings. For example, if a companys P/E ratio is 10 that meant investors are willing to
pay (per share) $10 right now for every $1 the company is expected to earn in the future.
What is a good P/E ratio? Should investors look for companies with high P/E ratios? Should
investors look for companies with low P/E ratios? Unlike the dividend discount model, there is
really no clear-cut answer on what the size of a P/E ratio should be in order for a company to be
considered as a good investment. It depends on the investors investment philosophy.
Some investors look for companies with high P/E ratios because they believe these stocks exhibit
strong growth potentials. On the other hand, some investors focus on seeking out stocks with low
P/E ratios (i.e. the value investors) because they believe these stocks are cheap (i.e. they cost less
for the same $1 of earnings). Regardless of your investment philosophy, it is important for you to
understand how the P/E ratio of a company is determined and what are some of the factors that
influence it.
Deriving the P/E ratio is simple. All you have to do is divide the price per share by earnings per
share. However, if we want to know what affects the P/E ratio, we need to go back and look at
the constant-growth dividend discount model. The formula for the original model is as follows:
g k
D
P

1
0
Since we know the upcoming dividend, D
1
= (1b)E
1
(where b is the retention rate and E
1
is the
earnings per share in time 1), we can incorporate it into the above model as follows:
g k
E b
P

1
0
) 1 (
We can easily manipulate the formula and get the following results:
]
]
]

+
]
]
]

g k
kb g
k
E
g k
b k
k
E
P
1
) 1 (
1
1
0
We can derive the companys P/E ratio as follows:
]
]
]

+
]
]
]

+
g k
kb g
k k g k
kb g
k E
P 1 1
1
1
1
0
What happens if the company fails to retain any of its earnings (i.e. b = 0)? In this case, the
company is not investing in any new projects and thus will not be growing (i.e. g = 0). As a
result, the P/E ratio of a no growth company is simply:
Investment Theory -15- Topic 7 Handout
k E
P 1
1
0

Referring to the previous model, we know the following term of a companys P/E ratio
represents its growth potential:
Growth potential ]
]
]

g k
kb g
k
1
We know that in order for an established company to grow, it has to have a positive growth
potential. In other words, the following conditions must hold:
k > g
g kb > 0 b(ROE) kb > 0 ROE > k
The first condition indicates that the required return is greater than the growth rate. The second
condition, which is the more interesting one, indicates that in order for a company to have a
positive growth potential, the company will have to invest in projects that generate returns (i.e.
ROE) that is greater than the investors required return. What if ROE is less than k? This means
that the return from the new projects is less than the investors required rate of return. In this
case, it is better for the company to simply distribute all the earnings as dividend payments rather
than retaining all or part of it for new projects.
[To be continued]
Investment Theory -16- Topic 7 Handout