In our quest to find the intrinsic value of stocks that we are interested in investing in, we have looked at several different types of formulas to help us determine that value. We haven’t considered the role that dividends play in these valuations, and as dividend investors, this is an important fact to factor in. Today we will discuss the dividend discount model to find the intrinsic value of dividend paying stocks.
Dividends are such an important variable to building our wealth, it is in our best interests to continue to add to our toolbox the different methods of calculating intrinsic value. The dividend discount model is simplicity itself and requires only three inputs to determine the value of a stock.
As we continue to strive to find the fair value of any stock that we wish to purchase, it is important to remember that the calculations that we do should never replace other methods of investigation, such as reading the 10-k, looking into other metrics, and doing our research.
In our efforts to narrow down our investing processes and learn more about different formulas to help us find intrinsic value, it is important to remember that we should try not to go down the rabbit hole in search of minutiae. A thought from Warren Buffett on intrinsic value.
“It’s better to be approximately right, than precisely wrong.”
That being said we should strive to be as accurate as we can, to help narrow down our errors in finding intrinsic value.
Dividend Discount Model Definition
So what is a dividend discount model?
The dividend discount model (DDM) is a procedure for valuing the price of a stock by using the predicted dividends and discounting them back to the present value. If the value obtained from the DDM is higher than what the shares are currently trading at, then the stock is undervalued.
One thing to keep in mind when utilizing this formula is the fact that it won’t work for a company that doesn’t pay a dividend. So, companies like Tesla, Netflix, Facebook, Amazon, and Alphabet wouldn’t work with this formula.
Dividend Discount Model Formula
This formula is as follows:
Fair Value = Next year’s expected dividend/discount rate – growth rate
The formula is calculated as follows. It is next year’s expected dividend divided by an appropriate discount rate subtracted from the expected growth rate.
Or: P = D / r – g
This requires three inputs to calculate the formula
- 1-year forward dividend
- Growth Rate
- Discount Rate
How the dividend discount model works is the model works off the idea that the fair value of an asset is the sum of its future cash flows discounted back to fair value with an appropriate discount rate.
Dividends are future cash flows for investors.
This particular model is also known as the Gordon Growth model and it was created by Myron Gordon and Eli Shapiro at the University of Toronto in 1956.
Today we will use the Gordon Growth model to calculate the intrinsic value of our examples. I have chosen to use this formula today as it is a little easier to calculate and we can use it for our more stable, mature companies.
For our first example, I will use Coca-Cola (KO) as they are to me, a very stable, mature company and should be a fine example of how this formula could work. Remember that we are trying to be approximately correct.
1 Year Forward Dividend Payment:
To calculate this number we will need to gather some information. I am going to use gurufocus.com to gather what I need to calculate this payment.
What we will need:
- Dividend payout ratio for 2016 = 96%
- Return on Equity 2016 = 8.95%
- Dividends per share 2016 = $1.40
Now that we have these numbers we can calculate the growth of the dividend payment for next year.
Expected growth rate = ( 1 – payout ratio ) Return on Equity
Expected growth rate = ( 1 – .96 ) .0895
Expected growth rate = 0.54%
Once that number is calculated we can take last year’s dividend and calculate next year’s expected dividend payment.
1-year forward dividend payment = dividends per share ( 1 + growth rate)
1 year forward dividend payment = 1.40 ( 1 + 0.0054 )
1 Year Forward dividend Payment = $1.41
To calculate the discount rate we are going to need to gather a formula for the discount rate which will be:
Discount Rate = Risk-Free Rate + Beta ( Risk Premium )
To make this formula work we need to find some numbers to plug into the formula.
- Beta for KO = .553
- Risk-Free Rate = 2.30%
- Risk premium = 5.69%
To find the Beta for Coke we can use Damodaran.com, which is a website run by Aswath Damodaran, who I’ve mentioned before. He is a professor of finance at NYU Stern and is a brilliant guy, and a fantastic teacher.
I use his calculator available on his site to calculate all my betas. You just need a ticker symbol for your company and a date range you would like it to calculate it for you.
I am going to use Coke and find a beta for a 10-year period, to try to find the most consistent number of our calculations.
Next, we need to find the risk-free rate for our formula. The risk-free rate is the theoretical rate of return of an investment with no risk, wouldn’t that be nice. I use the 10-year Treasury Bill rate for my risk-free rate, this would be the absolute return I would expect if there was no growth for my company.
And finally, we get to the risk premium for our formula. This is fairly easy to acquire as well. Just follow the link here. The risk premium is the difference between the expected market return on a market portfolio and the risk-free rate.
Again we are going to use the data that Professor Damodaran provides for all of us, free of charge.
Now that we have all the numbers for our formula, let’s go ahead and calculate our discount rate.
Discount Rate = Risk Free Rate + Beta ( Risk Premium )
Discount Rate = .023 + .553 ( .0569 )
Discount Rate = 5.44%
We have already calculated our growth rate when we were looking to find the growth rate for our dividend. So, this number has already been calculated for Coke.
Putting it all together
Now to solve for our dividend discount model we need to plug all the numbers into our formula and calculate the intrinsic value of Coke, via the dividend discount model.
Value = 1 year dividend rate / Discount rate – growth rate
- 1 year dividend rate = $1.40
- Discount rate = 5.44%
- Growth rate = 0.54%
Plugging the numbers into the formula.
Value = 1.40 / 0.0544 – 0.0054
Value = $28.57
So, based on our calculations with our dividend discount model we come up with an intrinsic value of Coke of $28.57, which compared to their current price of $42.95, as of April 12, 2017.
This indicates that this company is overvalued at this time and would warrant a further look into why it might be overvalued. As a further indicator of this pricing, I did a quick discounted cash flow calculation and came up with a similar result.