Stock valuation: the Dividend Discount Method
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The Dividend Discount Method (DDM) is an old and highly conservative method of stock valuation and this part of the finance curriculum that students learn in their introduction to finance courses. Though it is pretty straight forward in theory, it is far more complicated to apply in practice because you have to make many assumptions about dividends and growth as well as the trend of future interest rates. The basic idea is simple enough in that the value of a stock is represented by the current and future dividends paid to the investor. A common method of stock valuation is to calculate the discounted value of all future cash flows accruing to the investor using a rate that is adjusted for risk. In the DDM, the cash flows that the investor receives are the sum of present and future dividends.
To use the DDM to value a particular stock, you calculate the value of whatever future dividends you think an investor will receive and then calculate the value using the price and an appropriate discount rate. To keep the calculations simple, that is suppose that you expect a dividend of one dollar a year as far ahead as you can foresee. If the risk-adjusted rate of return you expect is 10%, according to the DDM, the value is one dollar divided by 10% or $10.
This simplistic calculation does not take into account the expected growth of the company and hence the growth in its dividend rate. For this you need to calculate the constant growth DDM (also referred to as the Gordon model). If you assume that the company that you are valuing will see a 5% growth in dividend rate every year, you need to subtract this growth from the number in your denominator. Taking the same example as above, you will need to divide one dollar by the 10% return minus the 5% growth rate in dividend. This will give you a value of $20 per share. These DDM models are not particularly suitable for valuing high-growth companies and work best with income stocks (aka widows stocks) such as utility companies that pay high dividends because they do not need to retain their earnings to finance growth.
The proponents of the DDM method of valuation hold that the only basis for valuation should be the dividends that you receive in the future and the other measures such as P/E ratio are unreliable. As you would have observed, the DDM requires many assumptions when you are trying to forecast a future dividend flow. You are also making an assumption that the dividend payment will be made every year and that the dividends will continue to grow with business growth. These are unreliable assumptions especially when you are trying to look years into the future. Moreover, many high-growth companies retained earnings to finance their future growth and reward their shareholders with stock price increases rather than dividends. For instance, Microsoft paid no dividends for any years and the DDM will tell you that the stock is worthless which is an absurd assumption.
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