 Personal Finance PowerPoint Presentation. Dividend Discount Model, DDM. Prepare to get financially fit by practicing personal finance. Most of this information comes from Investopedia, Dividend Discount Model, DDM, which you can find online. Take a look at the references, resources, continue your research from there. This by James Chen, updated March 6th, 2022. In prior presentations, we've been taking a look at investment goals, investment strategies, investment tools, keeping in mind the two major categories of investments, that being the fixed income, typically the bonds, the equities, typically the common stock. Also note the tools that you are using, which might include things like mutual funds and ETFs, pooling investments together to help you to diversify where you might be using different strategies than if investing in individual stocks where you might be looking more than at the financial statements, ratio analysis, trend analysis for those particular stocks. Keeping that in mind, what is the dividend discount model? The dividend discount model, the DDM, is a quantitative method used for predicting the price of a company stock based on the theory that its present day price is worth the sum of all its future dividend payments when discounted back to their present value. So we've talked about fixed income and the past is kind of probably is more intuitive when you think about the fixed income and bonds, for example, because when we thought about bonds, we know that we're gonna get paid generally some kind of interest payments, which is an annuity possibly semi-annually, for example, and then we're gonna get the amount at the end of the bond at maturity. And we can think about valuing that bond then by looking at those future streams of income, either taking an annuity of the interest payments and then a present value of one of the maturity, or we can take a year by year layout of our future values and kind of present value them back to the current timeframe. That's how we can figure out what the current value is possibly pricing the bond. We can use that same method for any kind of investment or stream of income that's gonna happen into the future. We can say, hey, look, I wanna look at this investment by the future streams of income that we are going to be receiving and then try to discount those incomes back to the present value. And that's one way that we can kind of value something. The problem with stocks in doing that is because when we invest in stocks, which is like us owning a component of the company, corporations being a separate legal entity broken out into the sections of the stocks, typically traded on the stock exchange, we then buy the stock in hopes to get a return either in the format of dividends that are gonna be paid back to us or in the format of the stock price going up in value and possibly we can then sell the stock. So then how are we gonna use that same method of valuation? Well, we can try to assume that if I was to hold the stock basically indefinitely, what's the stream of dividends that we would get throughout that indefinite holding of the stocks? And then we can use that future stream of dividends, which would be the earnings of the company that are paid out in the form of dividends perpetually basically on forever. Obviously as we get closer to infinity, those future dividends are gonna be worth less because we're gonna discount them to the point where they're gonna become non-consequential in our calculation at some point you would think, right? And so we can use that same kind of approach even though it's a little bit theoretically more complex. So it attempts to calculate the fair value of a stock irrespective of the prevailing market conditions and takes into consideration the dividend payout factors and the market expected returns. So if the value obtained from a DDM, that's the dividend discount model, is higher than the current trading price of shares, then the stock is undervalued and qualifies for a buy or vice versa. So if you did this future value stream of dividend payments to value the stock and that became higher than what the current market is determining the stocks are, you could take action at that point based on it. Understanding the DDM. A company produces goods or offer services to earn profits. That's what companies do. And that's why we invest in them. They're gonna take our money, our capital, our assets, our cash, buy things with them assets to use to generate revenue, hopefully being able to generate a return greater than what we could do by just putting our cash elsewhere. The cash flow earned from such business activities determines its profits, which gets reflected in the company's stock price. Companies also make dividend payments to stockholders, which usually originates from business profits. So clearly if they make money, they could put it back in the company, generating an increase in the equity value, hopefully increase in the market price, or they can give it to us in the form of dividends. So the DDM model is based on the theory that the value of a company is the present worth of the sum of all its future dividend payments. Time value of money. Imagine you give $100 to your friend as an interest-free loan. After some time, you go to him to collect the loan to money. Your friend gives you two options. Take your $100 now, take your $100 after a year. Most individuals will opt for the first choice. Of course, taking the money now will allow you to deposit it in the bank. Even if you fully trusted your friend to give it to you in a year, because you don't know, maybe the friend moves and you don't never see the guy again or whatever. But even if you trusted him, you still want the money today because you could put it in the bank and earn money on it. So that's time value of money. If the bank pays a nominal interest, say 5%, then after a year, your money will grow to 105. It will be better than the second option where you get $100 from your friend after a year mathematically. So future value is the present value times one plus the interest rate. So the above example indicates the time value of money which can be summarized as money's value is dependent on time. So clearly you'd rather have the cash today, please, because the money of cash today has value because it could be put to work by giving it to someone who could do stuff with it, buy stuff that can generate revenue and whatnot. Looking at it another way, if you know the future value of an asset or a receivable, you can calculate its present worth by using the same interest rate model. We got the rearranging the equation, present value equals the future value divided by one plus the interest rate. So in essence, given any two factors, the third one can be computed. The dividend discount model uses this principle. It takes the expected value of the cash flows a company will generate in the future and calculate its net present value drawn from the concept of the time value of money. So we'll lay out all the future cash flows that we expect to be receiving from the investment, which again is like, how would you do that? That's kind of weird because it's gonna go on forever because the company doesn't in theory go out of business or may, you know, it could live forever in theory. So, but obviously when you go way out into the future, we're gonna discount it back and those will be less, very lesser value because of the time value of money. Essentially the DDM is built on taking the sum of all future dividends expected to be paid out by a company and calculating its present value using a net interest rate factor also called a discount rate. Expected dividends estimating the future dividend of a company can be a complex task. Analysts and investors may make certain assumptions or try to identify trends based on past dividend payment history to estimate future dividends. So one of the problems of course is, well, how do I know what their dividend policy is gonna be going forward? You gotta look at the past and possibly anything they've been telling us or trends to determine the stream of dividends we would expect to be receiving perpetually out into the future. One can assume that the company has a fixed growth rate of dividends until perpetuity, which refers to a constant stream of identical cash flows for an infinite amount of time with no end date. So you might say, hey, when the company's growing, I'm gonna assume that they're gonna increase their dividends at this fixed rate until they cap out at some point when they're up at the top end of their business cycle. At that point, they're an established company and they're just gonna give a fixed dividend that won't change much from that point forward, for example. So for example, if a company has paid a dividend of $1 per share this year and is expected to maintain a 5% growth rate for dividend payments, the next year's dividend is expected to be $1.05. Alternatively, if one spot a certain trend, like a company making dividend payments of $2, 250, $3, 350 over the last four years then, an assumption can be made about this year's payment being $4 because it kind of continues with the trend. You see the trend, you see the trend, such as expected dividend is mathematically represented by D. So discounting factor, shareholders to who invest their money in stocks take a risk as their purchase stock may decline in value. Against this risk, they expect a return compensation. Similar to a landlord renting out his property for rent, the stock investors act as money lenders to the firm and expect a certain rate of return. A firm's cost of equity capital represents the compensation for market and investors' demand in exchange for owning the asset and bearing the risk of ownership. In other words, what's gonna be the discount rate that we're gonna use when we discount the payments and that's gonna be the cost of our capital, the cost of our money, what we can basically invest alternatively. For example, you might think of it, what would be the second best place that we can kind of put our money could help us to gauge what the discount rate is gonna be when we do this valuation. So this rate of return is represented by R and can be established using the capital asset pricing, CAPM or the dividend growth model. However, this rate of return can be realized only when an investor sell his shares. The required rate of return can vary due to investor discretion. Companies that pay dividends do so at a certain annual rate which is represented by G. The rate of return minus the dividend growth rate, R minus G, represents effective discounting factor for a company's dividend. The dividend is paid out and realized by the shareholders. The dividend growth rate can be estimated by multiplying the return on equity, the ROE by the retention ratio, the latter being the opposite of the dividend payout ratio. Since the dividend is sourced from the earning generated from the company, ideally it cannot exceed the earnings. The rate of return on the overall stock has to be above the rate of growth of dividends for future years. Otherwise the model may not sustain and lead to results with negative stock prices that are not possible in reality. So the DDM formula based on the expected dividend per share and the net discount factor, the formula for valuing a stock using the dividend discount model is mathematically represented as the value of stocks, the EDPS divided by the CCE minus the DGR where the EDPS is the expected dividend per share divided by the, I mean, over the cost of the capital equity minus the dividend growth rate. We might do some examples in Excel to get a feel for this. So I don't know, we might dig into that a bit more. So since the variables used in the formula include the dividend per share, the net discount rate represented by the required rate of return or growth of equity and the expected rate of dividend growth, it comes with certain assumptions. So here's the assumptions. Any model's gonna have kind of assumptions. We wanna learn how the model works and then try to think about when those assumptions would not be applicable. So since dividends and other growth rate are key inputs to the formula, the DDM is believed to be applicable only to companies that pay out regular dividends. So if you're looking at growth stocks that don't pay dividends because they're reinvesting the money into the company, it's gonna be difficult to use this model because you might say at some point they're gonna give dividends, but you'd have to make future projections of when that's gonna happen and so on. If however, it can still be applied to stocks which do not pay dividends by making assumptions about what dividends they would have paid, they would have paid otherwise. DDM variations, the DDM has many variations that differ in complexity, while not accurate for most companies, the simplest iteration of the dividend discount model assumes zero growth in the dividend in which case the value of the stock is the value of the dividend divided by the expected rate of return. So you could just take the current dividend and just keep it constant, right? And that would be a baseline method. The most common and straightforward calculation of a DDM is known as the Gordon growth model, the GGM, which assumes a stable dividend growth rate and was named in the 1960s after American economist, Marin G. Gordon. This model assumes a stable growth in dividends. So now you're gonna assume that the board of directors and the management decide a kind of a stable increase in the dividends that they're gonna give to the owners, the stockholders year over year. So to find the price of a dividend paying stock, the GGM takes into account three variables. You got D, the estimated value of next year's dividend, or the company's cost of capital equity and G, the constant growth rate for dividends in perpetuity. Using these variables, the equation for the GGM is price per share equals D over R minus G. A third variant exists as the supernormal dividend growth model, which takes into account a period of high growth followed by a lower constant growth period. Now this kind of follows what you would expect with a business cycle, because you would expect a business to kind of have a high growth and then kind of level off in their growth, right? And then it's gonna peak at some point and then it's gonna grow quite slowly or kind of taper off and you would expect not many dividends happening down here and then you would expect kind of more dividends to be happening at some point and then dividends increasing at some point and then you would expect if they last this long that the dividends would taper off and level off as the company's not growing much anymore, but it's stable and it's like acting kind of like a utility company and they're able to just pay out a fixed amount of their income, for example. So during the high growth period, one can take each dividend amount and discount it back to the present period. For the constant growth period, the calculations follow the GGM model, all such calculations factor are summed up to arrive at a stock price. Now notice when we use these little formulas, these are kind of simplified formulas. We could do this in Excel and just basically map out the dividends that we're gonna have for however many years we wanna go out into the future and present value each year instead of trying to use what would be the equivalent of like an annuity dividend calculation versus like a sum of one, we could just list out each year and that would be an easy way to do it although somewhat tedious but easy to do in Excel. So examples of the DDM, assume company X paid a dividend of $1.80 per share this year. The company expects dividends to grow in perpetuity at 5% per year and the company's cost of equity capital is 7%. The $1.80 dividend is the dividend for this year and needs to be adjusted by the growth rate to find D1, the estimated dividend for next year. So this calculation is D1 equals D0 times one plus G equals the $1.80 times the one plus 5% or $1.89 would be the dividend that we would expect for the following year. Next, using the GGM company X's price per share is found to be out to the D1 divided by R minus G or the 94.50. So a look at the dividend payment history of leading American retailer Wal-Mart Incorporated indicates that it has paid out annuals dividends totally $1.92, $1.96, $2.00, $2.04, $2.08 between January 2014 and January 2018 in chronological order. One can see a pattern of consistent increase of 4 cents in Wal-Mart's dividends each year, which equals to the average growth of about 2%. Assume an investor has a required rate of return of 5% using the estimated dividend of $2.12 at the beginning of 2019, the investor would use the dividend discount model to calculate per share value of $2.12 divided by 0.05 minus 0.02 equals $70.67. We might do some examples in Excel. I know I'm going through those examples fairly quickly, so we might dive into some of them in more detail later. Shortcoming of the DDM, while the GGM method and DDM is widely used, it has two well-known shortcomings. The model assumes a constant dividend growth rate in perpetuity. This assumption is generally safe for very mature companies that have an established history of regular dividend payments. However, DDM may not be best modeled to value newer companies that have fluctuating dividend growth rates or no dividend at all. One can still use the DDM on such companies, but with more and more assumptions, the precision decreases. The second issue with the DDM is that the output is very sensitive to the inputs, for example, and the company X example above, if the dividend growth rate is lowered by 10% to 4.5%, the resulting stock price is $75.24, which is more than 20% decrease from the earlier calculation price of $94.50. So you can have some somewhat modest adjustments you would think in some of the inputs with some radical adjustments in the price. The model also fails when companies may have a lower rate of return or compared to the dividend growth rate G. This may happen when a company continues to pay dividends, even if it is incurring a loss or relatively low earnings. Using DDM for investments, all DDM variants, especially the GGM, allow valuing a share exclusive of the current market conditions. It also aids in making direct comparisons among companies, even if they belong to different industrial sectors. So investors who believe in the underlying principle that the present day intrinsic value of a stock is a representation of their discounted value of the future dividend payments can use it for identifying overbought or undersold stocks. If the calculated value comes to be higher than the current market price of a share, it indicates a buying opportunity as the stock is trading below. It's fair value as per DDM. However, one should note that DDM is another quantitative value available in the big universe of stock valuation tools. So obviously this is just another tool in the toolkit and you wanna put it into your overall thinking and modeling. Like any other valuation method used to determine the intrinsic value of a stock, one can use DDM in addition to the several other commonly followed stock valuation methods. So some people might tend towards one or the other method, put more weight on them, but you wanna be aware of the different methods that are going to be used and your philosophy about how the market works will lead you to lean more heavily on one or another. Since it requires lots of assumptions and predictions, it may not be the sole best way to base investment decisions.