Dividend Discount Model in Stock Valuation Method
Stock investment decision making must be supported by analysis from many perspectives. There are many options in financial perspectives to estimate attractiveness of stock investment opportunities. Before deciding what company should be purchased in stock market, investors always calculate the fair value of current stock price with certain method whether it is overvalued or undervalued by the market. One of the common methods is Dividend Discount Model (DDM) in stock price valuation.
What is this model?
This model is a quantitative method widely used to predict the price of company’s stock based on the time value of money theory where its present day price is worth the sum of all of its future dividend payments when discounted back to their present value. Zero-Growth, Constant-Growth, and Variable-Growth Models are the variations of DDM to determine whether the stock should be bought or not. The variations differences are explained appropriately with their name, Zero-Growth for fixed dividend payment, Constant-Growth for constant increase payment of dividend, and Variable-Growth for vary payment of dividend payment.
How it works?
It works by calculating intrinsic value of estimated future dividend streams with formulas in the time value of money concept and also adapting the discount factor rate derived from Capital Asset Pricing Model (CAPM) or Weight Average Cost of Capital (WACC) concepts. If the intrinsic value of total estimated future dividend streams is less than actual price in market, it indicates that the actual price may be overvalued. If the intrinsic value of total estimated future dividend streams is more than actual price in market, it indicates that the actual price may be undervalued. When the stock valuation is undervalued, it suggests the investor to purchase the stock. These are the formulas for each variations for calculating the intrinsic value of dividend payments;
Zero-Growth Model :
Constant-Growth :
Variable-Growth Model :
Information :
P0 = Value of common stock; D0 = Most recent dividend; D1 = Amount of the annual dividend; DN = Amount of the dividend at period N; ks = Required return on common stock; g = Constant dividend growth rate; g1 = Initial dividend growth rate at 1; g2 = Growth rate after the shift; N = Period; t = Period
What is the limitation?
This model is not suitable for companies who don’t pay dividend for their shareholder or new-born companies. It is more suitable for mature companies which have history to pay dividend. Estimating the future dividend streams is not easy task. It may contain errors in estimating dividend growth rates and also inaccurately measure the discount factor. This model also fails when companies may have lower rate of return compared to the dividend growth rate. Other than that, DDM is commonly used and one of the simplest way to evaluate the stock’s market price.
Is the result of this model an absolute suggestion for investor?
There is no absolute suggestion for investor. DDM could be one aspect of investment decision making in stock market, but the suggestion from DDM must be assisted and supported with other analysis. This is only one perspective in financial theory that somehow different with actual investment decision making behavior. As we know that recently investors are still buying stocks even though the actual market price is heavily overvalued than its intrinsic values. The reason is that they have their own considerations other than dividend.
References :
- Gitman, Lawrence J., and Chad J. Zutter. Tenth Edition. Principles of managerial finance
- https://en.wikipedia.org/wiki/Dividend_discount_model
- https://www.investopedia.com/terms/d/dcf.asp
- https://www.investopedia.com/terms/g/gordongrowthmodel.asp
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Nice article, complete information as a first step for investors in making decisions..
Nice post Mr.Dhanur, btw what another analysis that can be supported DDM, for make the suggestion for investor complete ?
thanks for sharing mas bas, really interesting to know different model of how stock be valuated. so this is applicable to blue chips stocks?
This is very new for me, thank you for sharing mas bastian
Thank you Mrs. Shandy, i wish it will be useful for your future investment decision making
Thanks for good question Mr. Indra, other than Dividend Discount Model, Free Cash Flow Model is usually used for other evaluation method and can be used in a firm who doesn’t have dividend payment history. Profitability ratio such as Price to Earning Ratio and also Debt Ratio such as Debt to Equity and Interest Coverage can be used to measure firm’s profitability and its default risk
Thanks for the response Mr. Devid, dividend discount model is very applicable for blue chip stock such as companies listed in LQ45 in Indonesia. As we know that most of the companies inside the LQ45 usually pay dividend to its investor in every year, so this method can be used properly to evaluate firms’s fair price
Thanks Mrs. Grace, i hope it will be useful for you