What Is A Dividend Discount Model?

The dividend discount model (DDM) is one of the basic starting points for valuing a company. Known for its simplicity and conservatism, the DDM tends to give us a very “safe” estimate of the value of a company.

As all 30 constituents of the current incarnation of the Straits Times Index (SGX: ^STI) pays a dividend, the DDM is one method we could use in valuing them.

Dividend Discount Model

There is an old saying, “A bird in the hand is worth two in the bush”. Taking on that concept, the DDM values a company based on the amount of dividend that would be distributed to shareholders instead of being retained in the company. This is akin to viewing an equity investment as a bond with its fixed interest payments.

The basic form of the dividend discount model thus becomes:

Share Price = (Expected Dividend Per Share One Year From Now / Discount Rate)

Using the equation above assumes that a company will have a constant dividend throughout its life. It’s easy to see how such an assumption can be flawed.

For one, a company is a dynamic organization and it is most likely not going to pay out constant dividends throughout its life. For example, Jardine Matheson Holdings (SGX: J36) has been growing its dividends over the past decade and more.

In that case, we can add a growth factor into our formula to depict a constant growth model. The modified formula is also known as the Gordon Growth Model, named after its founder, Myron Gordon. It’s shown below

Share Price = Expected Dividend Per Share One Year From Now / (Discount Rate – Growth Rate)

Let’s look at a numerical example for a better illustration. Imagine that we have now found a company that’s expected to grow its dividend at a constant rate of 3% per year, with an expected dividend of $1 per share in the next 12 months. For simplicity’s sake, let’s  use a discount rate of 10%.

If we plug in all the numbers into the DDM, the following will be what we obtain:

Share Price = 1 / (0.1 – 0.03) = $14.30

If the company is currently trading at less than $14.30, we can assume that the company is undervalued by the market.

Foolish Bottom Line

There isn’t a fixed method in valuing a company. The DDM is just one of many methods. Other valuation methods include using P/E ratiosP/B ratios, and the Discounted Free Cash Flow model .

As an investor, it is most important to find a method that you are most comfortable with, and be consistent in applying that method in your search for companies to invest in.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.