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The Dividend Discount Model Explained

By Sure Dividend on March 23, 2016 3:33 pm in Value Investing

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The Dividend Discount Model Explained: [+3 Free Excel Downloads] by

Ben Reynolds, Sure Dividend
The Dividend Discount Model is a valuation formula used to find the fair
value of a dividend stock.

Everything should be as simple as it can

be, but not simpler Attributed to Albert
Einstein
The elegance of the dividend discount model is its simplicity. The

dividend discount model requires only 3 inputs to find the fair value of a
dividend paying stock.
1.

1 year forward dividend

2.
3.

Growth rate
Discount rate

Dividend Discount Model Formula

The formula for the dividend discount model is:

The dividend discount model is calculated as follows. It is next years

expected dividend divided by an appropriate discount rate less the
expected dividend growth rate.
This is abbreviated as:

Alternate Names of the Dividend Discount Model

The dividend discount model is often referred to by 3 other names:
1.
2.
3.

Dividend Growth Model

Gordon Growth Model

Dividend Valuation Model

The Dividend Growth Model, Gordon Growth Model, and Dividend

Valuation Model all refer to the Dividend Discount Model.
Myron Gordonand Eli Shapiro at created the dividend discount model
atthe University of Toronto in 1956.

How The Dividend Discount Model Works

The dividend discount model works off the idea that the fair value of an
asset is the sum of its future cash flows discounted back to fair value
with an appropriate discount rate.
Dividends are future cash flows for investors.

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Imagine a business were to pay $1.00 in dividends per year, forever. How
much would you pay for this business if you wanted to make 10% return
on your investment every year?
10% is your discount rate. The fair value of this business according to
the dividend discount model is $10 ($1 divided by 10%).

We can see this is accurate. A$10 investment that pays $1 every year
creates a return of 10% a year exactly what you required.

The dividend discount model tells us how much we should pay for a
stock for a given required rate of return.

Estimating Required Return Using the CAPM

CAPM stands for capital asset pricing model. It is a critical financial
concept to understand.Click here to see 101 important financial ratios
and metrics.
The capital asset pricing model showsthe inverse relationship between
risk and return(in theory,not so much in practice) .

The required return for any given stock according to the CAPM is
calculated with the formula below:

What is the current market risk premium?

The long-term inflation adjusted return of the marketnot accounting for
dividends is 2.2%. Inflation is expected tobe at 1.7%over the next
decade. The current dividend yield on theS&P 500 is 2.2%. A fair
estimate of market return to use in the CAPM formula is 6.1% (2.2% +
1.7% + 2.2%).
The currentrisk free rate is 0.3%. The risk-free rate is traditionally
calculated as the yield on 3-month T-Bills.
All that is left to calculate the required return on any stock using the
CAPM is beta. Beta over a 10 year period is calculated below for
3Dividend Aristocrats:

Aflac (AFL) has a beta of 1.5

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PepsiCo (PEP) has a beta of 0.5

Archer-Daniels-Midland (ADM) has a beta of 1.0

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These betas imply a required return of:

Aflac has a required return of 9.5%

PepsiCo has a required return of 3.4%

Archer-Daniels-Midland has a required return of 6.4%

Beta has a significant effect on the required returns of different stocks.

PepsiCo in particular has an exceptionally low required return. PepsiCo
has a dividend yield of 2.8%. The CAPM implies that PepsiCo need only
grow at 0.6% a year and pay its dividend to satisfy investors.

The Importance of The Dividend Growth Rate

The dividend growth rate is critically important in determining the fair
value of a stock with the dividend discount model.
The denominator of the dividend discount model is discount rate minus
growth rate.The growth rate must be less than the discount rate for the
dividend discount model to function. If the growth rate estimate is
greater than the discount ratethedividend discount model will return a
negative value.

There are no stocks worthanynegative value. The lowest value a stock

can have is $0 (bankruptcy with no sellable assets).
Changes in the estimated growth rate of a business change its value
under the dividend discount model.
In the example below, next years dividend is expected to be $1 multiplied
by 1 + the growth rate. The discount rate is 10%:

$4.79 value at -9% growth rate

$5.88 value at -6% growth rate
$7.46 value at -3% growth rate
$10.00 value at 0% growth rate
$14.71 value at 3% growth rate
$26.50 value at 6% growth rate
$109.00 value at 9% growth rate

Longer Growth Rates Push Value Out In Time

The closer the growth rate is to the discount rate, the more time it takes
to approach the present value ofdiscounted future cash flows.

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The chart below shows the percentage of fair value reached through time
for different growth rates. A discount rate of 10% and an expected
dividend of $1 multiplied by $1 + the growth rate is used.

Businesses with a wide gap between the discount rate and the growth
rate converge on their fair value faster. There is a hidden advantage
here.You dont have to be right for as long.

If you have a required return of 10% and estimate dividend growth at 0%

a year (no growth)it would take 8 years for discounted cash flows to
reach ~50% (53%, exactly) of fair value.

With a 9% growth rate, only 7% of fair value is reached after 8 years. The
business will have to grow at 9% for 75 years to reach 50% of its fair
value. Growth rates are difficult to calculate over 1 year. How anyone
can push growth rates out 50 or 75 years and have any confidence in
them is beyond me.

It is impossible to have any idea what a business will be doing in 75

years, even in extremely stable industries. At best, we can say a
business will probably exist in 75 years. Saying it will still be growing at
9% a year in 75 years is impractical.

Estimating The Dividend Growth Rate

The dividend growth rate must approximate the growth rate of the
business over long time periods. If dividend growth exceeded business
growth for long dividends will be more than 100% of cash flows. This is
impossible over any meaningful length of time.
Long-term earnings-per-share growth approximates long-term dividend
per share growth.

Using earnings-per-share growth over dividend-per-share growth has a

distinct advantage. Dividend growth can be inaccurate due to 1 time
increases in payout ratio.
A company can raise its payout ratio from 35% to 70% and double its

dividend. The companycannotrepeat the same trick over the next

period. The payout ratio cannot double againfrom 70% to 140% (at least,
it cant if it wants to stay in business).

Established businesses are easier to estimate future growth rates for. A

business like Coca-Cola will probably grow around the same rate over the
next decade as it has over the last decade.
Rapidly growing

businesses like Amazon

(AMZN)cannotgrow at
15% or 20% a year
indefinitely. If Amazon
grew its market cap at
20% a year over the next
30 years it would be
worthmore than $64
trillion. To put that into
perspective, the global

DOW 50,000

Stocks are on the cusp of an

historic surge. Surprising
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GDP is currently around

$73.5 trillion. Rapidly
growing businesses growth rates should be reduced to more accurately
reflect future growth.

Dividend Discount Model Excel Spreadsheet

Calculator
Download a free Excel Spreadsheet dividend discount model calculator
at the link below:
Dividend Discount Model Excel Spreadsheet Calculator
The calculator has detailed instruction inside the spreadsheet on how to
use it.

The Implied Dividend Growth Rate

The dividend discount model can tell us theimplieddividend growth rate
of a business using:

Current market price

Beta
Reasonable estimate of next years dividend.

To do so we need only rearrange the dividend discount model formula to

solve for growth rather than price.

Lets use Wal-Mart (WMT) as an example:

Share price of $67.44

Estimated dividend next year of $2.04
10 year Beta of .53

Using the Beta above with our previously calculated 6.1% expected
market return and 0.3% risk-free rate gives us a CAPM required return of
3.5% to use for our discount rate.
Plugging these numbers into the implied dividend growth formula gives
animplied dividend growth rate for Wal-Mart of just 0.5%.
While its true that Wal-Mart has struggled as of late, it is very likely the
company grows at a faster clip than 0.5% a year.
Comparing the implied growth rate to reasonable growth
expectationscan turn up potentially undervalued securities.
We will run through the same example with Cummins (CMI).

Share price of $105.12

Estimated dividend next year of $4.28
10 year Beta of 1.58

CAPM discount rate of 9.9%

Implied dividend growth rate of 5.8% over the long run

Cummins has grown its earnings-per-share at 11% a year over the last
decade. The company is currently struggling due to a global growth
slowdown. However,long-term growth prospects remain bright. Again,
Cummins appears undervalued when comparing historical growth
numbers to market expectations.

Both Cummins and Wal-Mart are favorites ofThe 8 Rules of Dividend

Investingthanks to their valuation, long-records of growth, and above

average dividend yields.
Click the link below to download an implied growth rate dividend
discount model calculator:
Implied Growth Rate Excel Spreadsheet Calculator

Top 10 Dividend Aristocrats Using The Dividend

Discount Model
In December of 2014 I published an article on the10 cheapest Dividend
Aristocratsusing the dividend discount model.
The annualized return from each of the top 10 is shown below. The
return of the S&P 500 ETF (SPY) and Dividend Aristocrats ETF (NOBL) are
also show below for comparison:

S&P 500 annualized total return of -0.4%

Dividend Aristocrats annualized total return of 2.8%
McDonalds (MCD) annualized total return of 28.7%
Clorox (CLX) annualized total return of 19.9%
AT&T (T) annualized total return of 17.5%
Kimberly-Clark (KMB) annualized total return of 15.3%
Coca-Cola (KO) annualized total return of 7.5%
PepsiCo (PEP) annualized total return of 6.3%
Johnson & Johnson (JNJ) annualized total return of 4.9%
Procter & Gamble (PG) annualized total return of -7.8%

Abbot Laboratories (ABT) annualized total return of -8.3%

Wal-Mart (WMT) annualized total return of -15.9%

Seven outof the top 10 Dividend Aristocrats using the dividend discount
model outperformed the S&P 500 and the Dividend Aristocrats Index.

The chart below shows the value of $1 invested SPY, NOBL, and in an
equal weighted portfolio of the Top 10 Dividend Aristocrats using the
dividend discount model.

An equal weighted portfolio (with no rebalances) of the Top 10 Dividend

Aristocrats using the dividend discount model has performed very well
since late December 2014.
This outperformance is likely due to the tilt towards lower beta stocks
that the dividend discount model has. The market has been essentially
falt in the period above. Low beta, high quality dividend stocks tend to
perform well in this environment.

The expected growth rates of many Dividend Aristocrats are higher than
their CAPM discount rates. This makes using the dividend discount
model as is impractical in this case.

I have calculated theimpliedgrowth rate for all of the Dividend

Aristocrats using the dividend discount model to account for this. I then
subtract the implied growth rate from the expected growth rate.
Thisshows which Dividend Aristocrats have the biggest difference
between expected and implied growth.
The Top 10 Dividend Aristocrats using the dividend discount model now
are:
1.
2.
3.
4.
5.
6.
7.
8.

W. Grainger (GWW)
Abbott Laboratories (ABT)
Hormel (HRL)
Becton Dickinson (BDX)
Ecolab (ECL)
Procter & Gamble (PG)
Coca-Cola (KO)
PepsiCo (PEP)

9. VF Corporation (VFC)
10. Walgreens Boots Alliance (WBA)

You can download a spreadsheet of all 50 Dividend Aristocrats ranked

using the difference between expected and implied dividend growth from
the dividend discount model at the link below:
Dividend Discount Model Dividend Aristocrats Excel Spreadsheet

Shortcomings of the Dividend Discount Model

The dividend discount model values a stockin perpetuity. No business
exists forever. The model ascribes a positive value (albeit negligible) to
dividends paid 100+ years from now.

I am a firm believer in theefficacy of long-term investing. Making 100+

year forecasts is foolish, even for the longest of long-term investors.

The dividend discount model does not work on businesses thatdo not
pay dividends. Google (GOOG) certainly has a positive value, even though
it doesnt pay dividends. This shortcoming makes the dividend discount
model a useful toolonly for dividend paying stocks(as the name implies).
The dividend discount model says the fair value of a business is the sum
of its future cash flows discounted to present value.
The model fails to account for cash flows fromselling your shares. Take
Google again. The company invests its cash flows into growth, not
paying dividends to shareholders. If the company can grow at 15% a
year, its stock price should (in theory) grow at 15% a year as well. When
investors sell the stock they will generate a very real cash flow. The
dividend discount model does not account for this.
The model also does not take into account changing payout ratios.
Some businesses will drastically hike their payout ratio. This
meaningfully affects the fair value calculation of the dividend discount
model.
Calculating the fair discount rate is also a serious drawback to the
dividend discount model. You can knowyourexpected return, but not
what the overall expected return of the marketshouldbe. The CAPM
does a poor job of coming up with real world discount rates.

Final Thoughts
The dividend discount model has serious flaws; but so does every other
valuation metric. Investing is an art, not a science. There is no one
perfect way to invest.
The dividend discount model is a useful tool to gauge assumptions
about a dividend stock. It is not the final word on valuation, but it does
provide a different way to look at and value dividend stocks.

This article contains 3 separate downloads. They are listed below as

well for easy access:

Implied Growth Rate Excel Spreadsheet Calculator

Dividend Discount Model Excel Spreadsheet Calculator

Dividend Discount Model Dividend Aristocrats Excel Spreadsheet

1,2 -View Full Page

Tags:

CAPM discount rates

dividend discount model

Dividend Aristocrats

dividend investing

S&P 500 ETF

Written by Sure Dividend

Sure Dividend is designed specifically to simplify the process of

investing in high quality businesses with shareholder friendly
managements for individual investors. Sure Dividend takes a
quantitative approach to this task, while providing qualitative
analysis backed up by fundamentals. The Sure Dividend approach
uses The 8 Rules of Dividend Investing to simplify the process of
investing in high quality dividend growth stocks.

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