Simple formula
The dividend discount method (DDM) is a
simple formula to determine the price (the intrinsic value) of a stock. The
stock value according to DDM is obtained by dividing annual dividend (D) with a
required rate of return (r) minus the dividend growth rate (g). By comparing
the result (P) with the actual price of the stock, the stock is seen as
overvalued (undervalued) if the result is lower (higher) then the actual price
of the stock. The formula may look similar to the formula for the present value
of a future cash flow, and this is what the DDM actually is. The future cash
flow is the dividend payment divided by the discount rate, assumed to be
constant.
The H-Model for non-constant dividend growth
The original formula assumes that the
dividend grows at the same rate forever. This may not be the case, for example
a stock may have a higher dividend growth rate during one stage followed by a
lower but more sustainable dividend growth afterwards. In this case a valuation
with the H-model is more appropriate.
The H-Model formula have new variables
which require an explanation. H is the number of years it takes for the stock
to shift from the higher dividend growth in the first period (ga) to
the second period with a lower dividend growth (gb). The shift
between g-values is here assumed to be linear during the period (H). I should
also say that in a scenario where the dividend growth is low initially followed
by a period of high dividend growth is also supported by the formula.
What is the required rate of return?
The required rate can be thought of as
the minimum return you (the investor) can accept from the stock. It’s important
to choose this variable carefully as its value will have a significant impact
on the result. It’s quite obvious that you won’t expect negative returns when
considering an investment, furthermore a negative value will yield a negative
price, so it has to be a positive value. On the other end picking a too large
value will give a very low price. Typically, the required rate of return is a
value larger than the dividend growth rate, somewhere between 9-15%. When
choosing the required return it’s better to be conservative and pick a high
value, some help might be found in the table.
r
|
Type of stock
|
Close to 9%
|
Stock of a very large company with long history of dividend
payouts. A “safe” investment
|
Somewhere between 9 and 15%
|
Other factors such as price volatility, sector riskiness and
strength towards competitors should be used to determine the r-value.
|
15 %
|
A riskier investment where you expect a higher return
|
Application
I have not prepared an example but I have made this handy
plugin for excel which allows you to apply the DDM on stocks. You need to pick
the historical time interval so that the dividend growth rate can be calculated
and you need to choose the required rate of return.
* I tested this on excel 2013 and can’t guarantee it works
on older/newer versions
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