Dividend Discount Model

by on November 25, 2013 in Course Preparation, Featured Articles, Finance Management, Financial Modeling Using MS Excel, Guests Column, Trainer Articles

Dividend Discount Model

Dividend Discount Models (DDM) define cash flows as the dividends to be received by the shareholders. As shareholder’s investment today is the present value of all the future dividends expected to be received. DDM based valuation models are used when the company has a history of paying dividends, the dividend policy is clear and related to the earnings of the firm and the asset/ investment is valued from the point of a minority shareholder. DDM:

Value can be calculated based on DDM under one period, two period or multi period holding periods depending upon the specific company/ case under consideration. Single period DDM for estimating value of a stock is given as under:

V0 = (D1 + P1) / (1 +r)

D1 = dividend in year 1, P1 = price after year 1, r = required rate of return Value of a stock using two –period DDM is given as under:

V0 = D1/ (1+r) + (D2+P2) / (1 +r)2

 Similarly multi-period DDM is calculated as

 V0 = D1/ (1+r) + D2/ (1 +r)2 +…+(Dn + Pn) / (1 +r)n

 DDM method also involves forecasting the terminal value based on certain methods such as Gordon constant growth model (GGM), Two stage growth model, H model and three stage growth model. Gordon model assumes that dividends increase at a constant rate indefinitely. The value is given as

V0 = D0 *(1+g)/ (r – g)

 Although being simple to use, GGM has certain limitations like difficulties in estimation of growth rates and unpredictable growth patterns of certain firms. Inorder to overcome these problems, multi stage growth models can be used where the firm is assumed to continue at a higher (present growth rate) for some foreseeable future and then a moderate growth rate (industry average) can be used for mature years. How to develop and use the Dividend Discount Model:

  • Key assumptions in developing DDM include Dividend per share for a foreseeable future and required rate of return on equity.
  • The two parameters need to be estimated based on certain inputs related to capital market information, cash flow details and financials of the company.
  • Required rate of return on equity can be estimated as follows:

Re = Rf + β* (Rm – Rf)

Here Rf = Risk free rate, β = beta of stock, Rm = market return/ benchmark return

  • The growth rate in EPS has been calculated in model as per the following formula:

g = R * {ROA + D:E *[ROA – I *(1 – T)]}

Here g = growth rate in EPS, ROA = Return on Asset, I = Interest rate, T = Tax rate

  • The terminal value of EPS has been calculated based on Gordon constant growth model assuming an industry average growth rate post 5 years of stabilization.
  • The dividend per share (arrived by EPS and dividend payout ratio of the firm) is then discounted by required rate of return to obtain present value of all dividends (including terminal value). The sum of present values is the value of stock obtained in the method.

Critical Concepts:

  • Advantage of dividends as cash flow is that dividends are less volatile than other measures (free cash flows or earnings), and therefore the value estimates derived from DDM are less volatile and reflect the long term earning potential of the company.
  • Major disadvantage of DDM is it is difficult to estimate for firms that don’t currently pay dividend or are yet to achieve stable state of growth rate (in turn stable % of dividend payment).
  • Another disadvantage of DDM is that it takes the perspective of an investor who owns a minority stake in the company and cannot control the dividend policy.
  • If dividend policy dictated by the controlling interests bears a meaningful relationship to the firm’s underlying profitability, then dividends are appropriate. If the dividend policy is not related to the firm’s ability to create value, then dividends are not an appropriate measure of expected future cash flow to shareholders.

See Sample Financial Model

Sivananda Dividend Discount ModelSivananda is currently Senior Manager (Large Corporate) at Axis Bank, He is an FRM from Global Association of Risk Professionals (GARP), USA, and also a CFA. He has previously worked with State Bank of India and Saint-Gobain. linkedin logo Dividend Discount Model

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