Dividend Discount Model
The dividend discount model (DDM) is a quantitative method used for predicting the price of a company's stock based on the theory that its present-day price is worth the sum of all of its future dividend payments when discounted back to their present value.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. If the value obtained from the DDM is higher than the current trading price of shares, then the stock is undervalued and qualifies for a buy, and vice versa.
Definition:
The Dividend Discount Model (DDM) is a financial method used to evaluate the intrinsic value of a stock. The theory posits that the current price of a stock should equal the sum of the present value of all its future dividends. By considering expected dividend payments and an appropriate discount rate, DDM estimates the fair market value of a stock. If the calculated value is higher than the market trading price, the stock may be considered undervalued; if lower, it may be considered overvalued.
Origin:
The concept of the Dividend Discount Model can be traced back to the early 20th century, but it was formally introduced and widely applied in the 1950s. The foundational theory was detailed by economist John Burr Williams in his 1940 book, "The Theory of Investment Value."
Categories and Characteristics:
The Dividend Discount Model mainly includes three types:
- Zero Growth Model: Assumes that the company's future dividend payments remain constant. Suitable for companies with stable and slow-growing dividends.
- Constant Growth Model (Gordon Growth Model): Assumes that the company's future dividends grow at a fixed rate. Suitable for companies with stable dividend growth.
- Multi-Stage Growth Model: Assumes that the company's future dividend growth rate will go through multiple stages of change. Suitable for companies with unstable dividend growth rates.
Specific Cases:
Case 1: Suppose a company currently pays a dividend of $2 per share, with an expected annual dividend growth rate of 5%, and the investor's required discount rate is 10%. According to the Constant Growth Model, the intrinsic value of the stock is calculated as follows:
Intrinsic Value = 2 / (10% - 5%) = $40
If the market price is below $40, the investor may consider the stock undervalued.
Case 2: Suppose another company currently pays a dividend of $3 per share, with an expected dividend growth rate of 8% for the next 5 years, and then stabilizes at 3%. The investor's required discount rate is 10%. According to the Multi-Stage Growth Model, the intrinsic value of the stock is calculated as follows:
Present value of dividends for the first 5 years = 3 * (1 + 8%) / (1 + 10%) + 3 * (1 + 8%)^2 / (1 + 10%)^2 + ... + 3 * (1 + 8%)^5 / (1 + 10%)^5
Present value of dividends thereafter = 3 * (1 + 8%)^5 * (1 + 3%) / (10% - 3%) / (1 + 10%)^5
Adding both parts gives the intrinsic value of the stock.
Common Questions:
1. What if dividends are unstable? For companies with unstable dividends, the Multi-Stage Growth Model can be used to more accurately reflect dividend changes.
2. How to determine the discount rate? The discount rate is usually determined based on the investor's required rate of return or the market average rate of return.
