Learn how to value stocks based on future dividends in just minutes!
Have you ever wondered how great investors determine the true worth of a company’s stock? Well, it’s no rocket science; it’s calculated easily by a financial tool called the Dividend Discount Model (DDM).
This article will break down the Dividend Discount Model, its calculation, usage, and more.
What is a Dividend Discounting Model?
The Dividend Discount Model (DDM) is a useful tool for determining the intrinsic value of a stock. It does this by closely examining the dividends a stock is expected to pay out.
However, when we discuss the value of a stock, we are talking about the total cash it is expected to generate for its shareholders in the future. This includes not just dividends but also any other forms of cash flows the company might generate.
We need to consider a few factors to assess the value of these future cash flows. Firstly, we must account for the time value of money, which means that the value of money today and in the future will be different. Secondly, we need to factor in the level of risk associated with these future cash flows because there is always some uncertainty in the business world.
Now, when we talk about DDM, it helps us calculate the value of a stock by taking the dividend into account from the list of the above-mentioned factors. Indeed, dividends are a significant part of these future cash flows. So, when we use the DDM, we are essentially determining the present value of all those future dividends and other cash flows, showing us how much they are truly worth to us in today’s terms.
Formula to Calculate Dividend Discounting Model (DDM)
Before calculating DDM, you need to calculate a few more things.
1. Estimate Future Dividends
First, you need to estimate the company’s future dividend payments. This often involves looking at its historical dividend payouts and analysing its growth prospects.
Let’s understand this with an example: you are considering investing in ABC Ltd, which currently pays an annual dividend of Rs 10 per share.
2. Determine the Discount Rate (r)
The discount rate (r) represents the return investors expect from their investments. For retail investors, a common approach is to use the company’s cost of equity. You can calculate this using:
Discount rate = Current Dividend/Current stock price + Growth rate of dividend.
In the above example, if the current stock price of ABC Ltd is Rs 100, and you estimate the expected growth rate to be 5%, then here is what the discount rate would be.
Discount rate = 10/100 + 0.5 = 0.15 or 15%
Next, we need to calculate the dividend expected next year.
Dividend next year = Current dividend x (1+ growth rate)
In this case, dividend next year = 10 x (1 + 0.05) = Rs 10.50
Now that we have the discount rate and the dividend expected next year let’s calculate the DDM.
Formula to calculate DDM is:
Target Price or Intrinsic Value = Expected dividend next year/discount rate – growth rate
= 10.50/0.15 – 0.05 = Rs 105
So, according to the DDM, the intrinsic value or target stock price for ABC Ltd is Rs 105.
Now that you have an estimated intrinsic value for a stock using DDM, you can compare it to the current market price.
When the intrinsic value exceeds the market price, it could indicate an undervalued stock. This could be a possible opportunity to buy. On the other hand, if the intrinsic value is less than the market price, it may suggest an overvalued stock, signifying a need for caution.
How Can Retail Investors Use DDM?
Retail investors can effectively use the Dividend Discount Model in the following ways:
1. Stock Selection
DDM can assist in identifying stocks that may be undervalued and have strong dividend potential. Look for stocks where the estimated intrinsic value, calculated using DDM, is significantly higher than the current market price. This suggests that the stock may be a good investment opportunity.
2. Long-Term Investing
DDM is particularly valuable for long-term investors who rely on dividend income. It helps in selecting stocks that offer a balance of growth potential and dependable dividend income over time.
3. Risk Management
By factoring in the discount rate in DDM calculations, you can assess the level of risk associated with a specific investment.
Higher discount rates indicate higher risk. Use DDM to align your investments with your risk tolerance and financial goals.
Limitations of DDM
1. Varied Dividend Policies
Not all Indian companies follow consistent dividend payout policies. Some retain earnings for reinvestment, while others distribute a significant portion of profits as dividends. This variability can complicate the estimation of future dividend payments. So, DDM seems to work well with consistent dividend offering companies.
2. Growth Uncertainties
Predicting the growth rate of dividends can be complicated due to various factors, including economic fluctuations and regulatory changes. These external influences can significantly impact a company’s ability to increase dividends consistently over time, making it important for investors to exercise caution when using DDM.
To conclude, Dividend Discount Model is a valuable tool for retail investors in India seeking to estimate the intrinsic value of stocks. But, Remember that DDM is just one of many tools in your investment toolkit, so use it alongside other ratios. With practice, DDM can become a powerful ally in your quest for smart and successful investments in the dynamic world of the stock market.
*The article is for information purposes only. This is not an investment advice.