Professional investors focus on figuring on out the value of a stock before investing in it by using the Dividend Discount Model. Buying at the right price is essential.

One of the most straightforward valuation techniques applied by the professionals is the Dividend Discount Model or DDM. As the name suggests, DDM is a model that helps investors deduce the value of a stock based on its dividend yield.

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The theory is pretty straightforward – a stock is worth the sum of dividends it’s expected to pay in the future, discounted back to present value. Dividends are free and tangible cash flows that investors can directly benefit from, which is why it makes sense to focus on these while valuing a company.

**The Basics of Discounting**

Let’s start with a simple question – is it better to receive $100 today, or $100 a year later?

Intuitively, you’d rather have the money today. Economically, money tends to lose its value over time. You can take the $100 today, stick it in a bank account that yields a 10% return and after a year you have $110. So, $100 is worth more today than $100 after a year.

Calculating the loss of value due to the passage of time is called discounting.

When we think of dividends, stocks pay them on an annual basis. You may receive a certain sum this year, and then a little more every year after that. These series of cash flows need to be *discounted *back to the present for us to calculate the value of the stock *today*.

**The Dividend Discount Model**

There are three basic elements to a dividend discount model – the expected dividend, the rate of growth in dividends and the discount rate.

This model accounts for all the factors that affect the dividends received on a stock. Most companies that pay a dividend tend to increase the payout every year. Dividends can be expected to grow at a steady rate over the long term. They must also be discounted back to the present value.

There are a lot of variations to the traditional dividend discount model, but the easiest one to use is the Gordon Growth Model. Here is the formula:

**P** is the fair price of the stock. Meanwhile, **D1** is the dividend expected next year,** r** is the rate of required return and **g** is the rate of growth.

It’s essential to get the inputs right in a model like this. If the growth rate or the discount rate is badly estimated, the intrinsic value will be over- or understated.

Here’s an example:
The annual dividend on a stock is $1. This dividend has grown 6% every year for the past 25 years, and is expected to grow at the same rate going forward. An investor who needs a 8% return on investment can use the dividend discount model to figure out how much the stock is worth. Using the Gordon Growth Model: r= 8% G = 6% |

**The Pros and Cons**

Dividend discount models are simple and easy to use. They also seem logical. The value of stock should be linked in some way to the cash investors get back for holding the stock. Dividends are directly linked to the free cash generated by the business, and some companies (like the dividend aristocrats) have a long history of steady dividend growth.

So, the model is quick and really effective. But it’s not without it’s flaws. The model is highly sensitive to the inputs like growth rate and require rate of return.

If the input values are estimated incorrectly, the fair value calculated is merely speculative. Even a minor change in the growth rate or the discount rate can seriously alter the end result. In the example above, if we assume the growth rate was 6.5% instead of 6%, the fair value shifts from $53 to $70.67.

The model also assumes a steady state of growth forever, which is not entirely realistic. Companies can grow their dividends over time, but this growth is unsteady and volatile. Sometime companies can also surprise investors with an unexpected dividend or a bonus. The traditional DDM models cannot account for sudden changes in the growth rate of dividends.

You can fix this by using a multistage DDM. These models are modified to account for different rates of dividend growth at different stages in the business’ life cycle.

To solve these issues, it’s best to use a multistage dividend discount model and pick stocks with higher dividend yields, rather than higher rates of growth. Multinational companies with lower growth rates are easier to predict and ideal for such models.

Also, apply a margin of safety to fair value estimates. Fair value is always an approximation and a margin of safety should protect against the lack of predictability.

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