The Dividend Discount Model Explained: [+3 Free Excel Downloads] by Ben Reynolds, Sure Dividend
The Dividend Discount Model is a valuation formula used to find the fair value of a dividend stock.
“Everything should be as simple as it can be, but not simpler” – Attributed to Albert Einstein
The elegance of the dividend discount model is its simplicity. The dividend discount model requires only 3 inputs to find the fair value of a dividend paying stock.
- 1 year forward dividend
- Growth rate
- Discount rate
Dividend Discount Model Formula
The formula for the dividend discount model is:
The dividend discount model is calculated as follows. It is next year’s expected dividend divided by an appropriate discount rate less the expected dividend growth rate.
This is abbreviated as:
Alternate Names of the Dividend Discount Model
The dividend discount model is often referred to by 3 other names:
- Dividend Growth Model
- Gordon Growth Model
- Dividend Valuation Model
The Dividend Growth Model, Gordon Growth Model, and Dividend Valuation Model all refer to the Dividend Discount Model.
Myron Gordon and Eli Shapiro at created the dividend discount model at the University of Toronto in 1956.
How The Dividend Discount Model Works
The dividend discount 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.
Imagine a business were to pay $1.00 in dividends per year, forever. How much would you pay for this business if you wanted to make 10% return on your investment every year?
10% is your discount rate. The fair value of this business according to the dividend discount model is $10 ($1 divided by 10%).
We can see this is accurate. A $10 investment that pays $1 every year creates a return of 10% a year – exactly what you required.
The dividend discount model tells us how much we should pay for a stock for a given required rate of return.
Estimating Required Return Using the CAPM
CAPM stands for capital asset pricing model. It is a critical financial concept to understand. Click here to see 101 important financial ratios and metrics.
The capital asset pricing model shows the inverse relationship between risk and return (in theory, not so much in practice) .
The required return for any given stock according to the CAPM is calculated with the formula below:
What is the current market risk premium?
The long-term inflation adjusted return of the market not accounting for dividends is 2.2%. Inflation is expected to be at 1.7% over the next decade. The current dividend yield on the S&P 500 is 2.2%. A fair estimate of market return to use in the CAPM formula is 6.1% (2.2% + 1.7% + 2.2%).
The current risk free rate is 0.3%. The risk-free rate is traditionally calculated as the yield on 3-month T-Bills.
All that is left to calculate the required return on any stock using the CAPM is beta. Beta over a 10 year period is calculated below for 3 Dividend Aristocrats:
- Aflac (AFL) has a beta of 1.5
- PepsiCo (PEP) has a beta of 0.5
- Archer-Daniels-Midland (ADM) has a beta of 1.0
These betas imply a required return of:
- Aflac has a required return of 9.5%
- PepsiCo has a required return of 3.4%
- Archer-Daniels-Midland has a required return of 6.4%
Beta has a significant effect on the required returns of different stocks. PepsiCo in particular has an exceptionally low required return. PepsiCo has a dividend yield of 2.8%. The CAPM implies that PepsiCo need only grow at 0.6% a year and pay its dividend to satisfy investors.
The Importance of The Dividend Growth Rate
The dividend growth rate is critically important in determining the fair value of a stock with the dividend discount model.
The denominator of the dividend discount model is discount rate minus growth rate. The growth rate must be less than the discount rate for the dividend discount model to function. If the growth rate estimate is greater than the discount rate the dividend discount model will return a negative value.
There are no stocks worth any negative value. The lowest value a stock can have is $0 (bankruptcy with no sellable assets).
Changes in the estimated growth rate of a business change its value under the dividend discount model.
In the example below, next year’s dividend is expected to be $1 multiplied by 1 + the growth rate. The discount rate is 10%:
- $4.79 value at -9% growth rate
- $5.88 value at -6% growth rate
- $7.46 value at -3% growth rate
- $10.00 value at 0% growth rate
- $14.71 value at 3% growth rate
- $26.50 value at 6% growth rate
- $109.00 value at 9% growth rate
Longer Growth Rates Push Value Out In Time
The closer the growth rate is to the discount rate, the more time it takes to approach the present value of discounted future cash flows.
The chart below shows the percentage of fair value reached through time for different growth rates. A discount rate of 10% and an expected dividend of $1 multiplied by $1 + the growth rate is used.
Businesses with a wide gap between the discount rate and the growth rate converge on their fair value faster. There is a hidden advantage here. You don’t have to be right for as long.
If you have a required return of 10% and estimate dividend growth at 0% a year (no growth) it would take 8 years for discounted cash flows to reach ~50% (53%, exactly) of fair value.
With a 9% growth rate, only 7% of fair value is reached after 8 years. The business will have to grow at 9% for… 75 years to reach 50% of its fair value. Growth rates are difficult to calculate over 1 year. How anyone can push growth rates out 50 or 75 years and have any confidence in them is beyond me.
It is impossible to have any idea what a business will be doing in 75 years, even in extremely stable industries. At best, we can say a business will probably exist in 75 years. Saying it will still be growing at 9% a year in 75 years is impractical.
Estimating The Dividend Growth Rate
The dividend growth rate must approximate the growth rate of the business over long time periods. If dividend growth exceeded business growth for long dividends will be more than 100% of cash flows. This is impossible over any meaningful length of time.
Long-term earnings-per-share growth approximates long-term dividend per share growth.
Using earnings-per-share growth over dividend-per-share growth has a distinct advantage. Dividend growth can be inaccurate due to 1 time increases in payout ratio.
A company can raise its payout ratio from 35% to 70% and double its dividend. The company cannot repeat the same trick over the next period. The payout ratio cannot double again from 70% to 140% (at least, it can’t if it wants to stay in business).
Established businesses are easier to estimate future growth rates for. A business like Coca-Cola will probably grow around the same rate over the next decade as it has over the last decade.
Rapidly growing businesses like Amazon (AMZN) cannot grow at 15% or 20% a year indefinitely. If Amazon grew its market cap at 20% a year over the next 30 years