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Complete Beginner’s Guide to Dividend Growth Models

Valuing of your dividends can be easily achieved with the use of dividend discount models. You can choose from a variety of dividend growth models that will suit you best.

First, let’s discuss what exactly is a dividend growth model or also known as a dividend discount model.

Dividend Growth Models

What is a Dividend Discount Model

The dividend discount model is also most commonly referred to as DDM. It is a procedure for valuing the price of a stock through the use of predicted dividends and then discounting them back to the present value. The value you obtain from this calculation will help you determine whether the stock is overvalued or undervalued.

Read more about the benefits and downside of dividend stock investing.

If the value obtained from the DDM is higher than the current trading price of shares, it means that the stock is undervalued. The stock is undervalued if the shares’ DDM value is higher than the current trading price. In contrast, the stock is overvalued if the shares’ DDM value is lower than the current trading price.

The dividend discount model is based on a certain idea. The idea is that the stock’s intrinsic value can be estimated by the expected value of the cash flows generated in the future. The main principle behind the model is the net present value (NPV) of the cash flows. The net present value draws from the concept of the time value of money (TVM).

Dividend Discount Model Variables

Variables of the dividend discount model include three factors. These variables are the dividend per share, the discount rate (also known as the required rate of return or cost of equity) and the expected rate of dividend growth. The model then does not work on companies who don’t pay dividends.

Basic formula:

  • Value of Stock = Dividend per share / (Discount Rate – Dividend growth rate)

The dividend discount model is considered to be inaccurate for most companies. Despite this, the simplest iteration of the DDM assumes zero growth in the model. In this situation, the value of the stock is merely the value of the dividend divided by the required rate of return.

The required rate of return is different due to investor discretion. Meanwhile, you can estimate the dividend growth rate by multiplying the return on equity (ROE) and the retention ratio. The retention ratio is the opposite of the payout ratio; it is the proportion of earnings kept back in the business as retained earnings.

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Variations of Dividend Discount Models

There are a lot of dividend discount model variations that have different levels of complexity.

1.      The Supernormal Dividend Growth Model

Supernormal dividend growth models consider the period of high growth which is then followed by a lower, constant growth period. In other words, it considers the time in which dividends issued on shares of a stock are rising at a higher than average rate. The term “supernormal” refers to the above normal growth rate of payouts.

There are three general models that every investor purchasing stocks based on dividend growth should remember:

  1. Dividend discount model with no growth in dividends.
  2. Dividend discount model with constant dividend growth
  3. Dividend discount model with supernormal dividend growth.

Despite the fact that the term “growth” is used, you still need to pay attention to the change in dividend payments. This will include the decreases in your discount models. With this, periods of different growth rates are discounted separately before combining to get the total value.

When these calculations are used, there are three variables that you must first determine. The variables are:

  • The required rate of return;
  • The time periods; and
  • The rate of growth

These three can prove to be difficult to predict. They can also cause drastic changes in the valuation of the stock.

Learn more about dividends with the pros and cons of DRIP.

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2.      Gordon Growth Model (GGM)

The Gordon growth model or GGM is the most common and straightforward calculation of a dividend discount model. This model was named after American economist Myron J. Gordon back in the 1960s. It assumes a stable dividend growth rate.

The Gordon growth model uses three variables when determining the price of a dividend-paying stock.

  • D = the estimated value of the dividend one year from now
  • k = required rate of return (taken from the capital asset pricing model
  • g = the expected growth rate for dividends, in perpetuity

With these variables, the resulting equation for the Gordon growth model is:

  • Price per share = D / (k – g)

Limitations

The Gordon growth model presents some limitations as well.

a.       The assumption of growth

Mainly, this can be seen in its assumption of a constant growth in dividends per share.

Companies rarely show constant growth in their dividends. This is mostly due to business cycles and the unexpected financial difficulties and successes every company faces.

With this in mind, the Gordon growth model is limited to companies or firms that show stable growth rates.

b.       Discount factor and growth rate

Another issue with the Gordon growth model has to do with the relationship between the discount factor and growth rate used in the model. The model can be rendered worthless if these variables are given certain values.

If the required rate of return is lower than the growth rate of dividends per share, the result will be negative value. This means that the model is rendered worthless.

Additionally, if the required rate of return is equal to the growth rate, the value per share almost reaches infinite value.

3.      Multi-stage Dividend Discount Models

Numerous future stream patterns of expected dividends can be accommodated in multistage dividend growth models. One of the tools you can use to assist you in using multistage dividend discount models are the spreadsheets. The spreadsheets will allow you – as the analyst – to build and analyze numerous permutations on such models.

Care and caution must still be exercised when choosing the model’s inputs or the results can become meaningless. Keep in mind that the spreadsheets are not perfect. They are prone to data errors that can result in inaccurate valuations.

The multistage dividend discount model makes use of the same variables as the GGM with one additional.

  • D = the estimated value of the dividend one year from now
  • k = required rate of return (taken from the capital asset pricing model
  • r = the company’s cost of equity capital
  • g = the expected growth rate for dividends, in perpetuity

The formula is as follows:

  • Price per share = [D (1 + g)/ (1 + k)] + [D (1 + g) (1 + g)/ (1 + r) (k – g)

Pros and Cons of Dividend Discount Models

Pros

  • Easy to Understand

Once you’re able to familiarize yourself with the math, the model can be easy to plug in and use anytime you want. You can consider it as a faster and easier way of getting through which stocks may be overpriced or underpriced.

  • Keep Your Dividend Paying Stocks

A number of studies have been able to prove that dividend paying stocks have been seen performing better than those companies that do not pay dividends. Using the dividend discount models will help you stay focused on the dividend paying stocks. It can also help you well into investing in some of them.

See more: Best Ways to Invest in Dividend Stocks

  • Highly Conservative

This model will not provide you with wild assumptions about the growth of a stock into the future. You can rest assured with its accuracy since the dividend growth rate can be higher than the rate of return in order for the formula to work.

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Cons

  • Limited Use

A dividend discount model can only be used in limited companies. It only applies to mature, stable companies able to prove themselves capable of consistently paying out dividends. It may seem like a good thing, but there is still a big trade-off. If you only invest in mature stable companies, you might miss out on high growth ones.

High growth companies offer investors a wide variety of opportunities. By definition, these types of company face numerous opportunities in the future. They can decide to develop new products or explore new markets, and in order to do so they might need to accumulate more cash. This means that the company has to raise more equity or debt. In turn, it automatically means that they cannot possibly afford the luxury of extra cash to pay dividends. As an investor relying on DDM, you might then miss these companies completely.

  • Too Much Assumptions

The dividend discount model involves plenty of assumptions. There assumptions regarding the dividends. Additionally, there are assumptions regarding interest rates, tax rates, and growth rate. Most of the factors mentioned here are beyond the control of the investors, which can reduce the model’s validity.

Conclusion

Always keep in mind that the dividend discount model will not work if one of the variables is inaccurate. This makes it considerably easier to put your trust in the dividend growth models’ accuracy. Consider your options sensibly before making any final decisions.

There are also some drawbacks that you should consider before committing yourself to the use of the dividend discount models. However, this is balanced out with the benefits you stand to reap. Do your research carefully and make sure that you have enough information before making a final decision.

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