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Summary The dividend discount model is a simple valuation model for dividend investors to use in valuation. Like all models, it is only as good as the inputs used. Regardless of its drawbacks, the use of models forces investors to forecast company results and evaluate their own risk tolerance, which can only be positive for investor returns and contentment. Valuation can be a tricky subject for investors managing their own portfolios. As investors, we might like a particular company, its business, and its future prospects. But what exactly is a fair price to pay? Sure, we can look at valuation measures like P/E and EV/EBITDA and compare those numbers against historical values, but then we are just speculating that the company will return to its long-run average. Is there a better way? Financial models can be one answer to that problem. Novice investors usually start with the dividend discount model. The dividend discount model is an extremely simple, conservative valuation technique for evaluating dividend-paying stocks. While every model has its weaknesses, I believe that at the bare minimum, applying the dividend discount model to your holdings encourages you to think about, understand, and then model your portfolio holdings. Understanding the application and foundations of the dividend discount model is fairly simple. It fits into the broad bucket of discounted cash flow analysis. What we are trying to accomplish when using the model is to put a value on what a company’s future dividend cash flow is worth to us in today’s money. When we talk about “discounting” those future cash flows, we’re adjusting those numbers to reflect its value today. For example, because of the time value of money, a payout of $1,000 one year from now is worth less than $1,000 to you today. Money today has the ability to earn returns and avoid inflation, something that money in the future cannot claim. The median point where we are ambivalent between two amounts of money at different times can help us calculate our required rate of return, along with evaluating the riskiness of holding a particular stock we are analyzing. So, if our required rate of return is 8%, the discounted value of $1,000 one year from now is $925.93 ($925.93 * 1.08 = $1,000). The Basic Formula (click to enlarge) What you’ll notice from the formula is that it assumes a constant dividend growth rate. We all know dividend growth rates vary from year to year, but in the best case for modeling, we attempt to use what the long-run average will be. The weakness here as well is that the greater the dividend growth, the more minor differences between your hypothesized growth and real-world results can skew our model. So this simplistic model works best for securities with lower dividend growth rates and stable earnings. For income investors, using this model for utilities stocks should spring to mind quickly. Real-World Application Example Below, we have an example of ALLETE (NYSE: ALE ), a utility that generates energy for customers in Wisconsin, Michigan, and other surrounding states. It currently trade at $48.55/share. I’ve written a fairly pessimistic article on ALLETE , but we can see if the results from the dividend discount model back or disprove my thesis, based on various inputs. ALLETE currently yields $2.02/share annually, and has grown its dividend at an average 2.2% annual rate for the past five years, so we’ll use those numbers to run our valuation, along with an 8% required rate of return. We will assume the dividend will be $2.12 next year. P = 2.12 / (.08 – .022) P = 2.12 / 0.058 P = $36.55/share Based on this valuation, we come to a fair value of $36.55/share, or roughly 25% below current prices. To show how the model can be sensitive, let us instead change our assumptions. Perhaps based on our research, we find that going forward, management will be able to raise the dividend 3.25% annually instead of 2.2%, because maybe we have found information that has led us to believe the utility will be allowed a higher rate of return by its regulators. Additionally, we find that our own required rate of return is only 7% for ALLETE, because the stock has less financial risk than we previously thought. P = 2.12 / (.07 – .0325) P = 2.12 / 0.0375 P = $56.53/share Our calculated fair value per share is now $56.53, or more than 15% above current prices. Which is correct? That depends, based on your analysis of management’s ability to continue to raise dividends into the future and your own assumptions on the riskiness of the holding, which factor into your required rate of return. Multi-Step Models What if we think the dividend will grow at 3.5% for the next five years for ALLETE, and then 2.25%, after using an 8% required rate of return? The dividend discount model can be adapted to be used for multiple stages of growth to suit the reviewer’s needs. Year One Dividend = $2.12 * 1.035 = $2.23 Year Two Dividend = $2.23 * 1.035 = $2.31 Year Three Dividend = $2.31 * 1.035 = $2.39 Year Four Dividend = $2.39 * 1.035 = $2.47 Year Five Dividend = $2.47 * 1.035 = $2.56 Year Six Dividend = $2.56 * 1.025 = $2.62 Once we have the values, we can then discount those to their net present value: $2.23 / (1.08) = $2.06 $2.31 / (1.08) 2 = $1.98 $2.39 / (1.08) 3 = $1.90 $2.47 / (1.08) 4 = $1.82 $2.56 / (1.08) 5 = $1.74 We can then apply the constant growth model we used previously to determine their value, based on the fifth-year dividend value: P = 2.62 / (.08 – .0225) P = 2.62 / 0.0575 P = $45.57/share This value has to be discounted to net present value as well. P = 45.57 / (1.08) 6 P = 45.57 / 1.5868 P = $28.72 Add up the values of the five higher-growth dividends with your constant growth value: P = 2.06 + 1.98 + 1.90 + 1.82 + 1.74 +1.65 + 28.72 P = $39.87/share Conclusion Like any and all financial models, the dividend discount model is sensitive to the inputs used to value the security. Thus, financial modeling isn’t the grand answer to record-beating returns, and I wouldn’t advocate for retail investors to bury themselves in Excel spreadsheet models. However, financial modeling can force investors to think about issues that are extremely important to the stock valuation process, which can drive critical re-evaluations of your positions based on your own inputs and expectations. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Scalper1 News
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