Dividend Discount Models (DDMs) are essential tools for estimating a stock's intrinsic value based on future dividend payments. These models help investors determine if a stock is overvalued or undervalued by comparing its current market price to the calculated present value of expected dividends.

DDMs come in various forms, including the constant growth model, two-stage model, and three-stage model. Each type has its strengths and weaknesses, with factors like dividend growth rates and required returns significantly impacting valuations. Understanding these models is crucial for making informed investment decisions.

Dividend Discount Models (DDMs)

Application of dividend discount models

• Estimate intrinsic value of a stock based on present value of expected future dividends
  • Intrinsic value represents fundamental value of a stock based on cash flows (dividends)
  • DDMs assume stock value equals sum of present values of all future dividend payments
• Steps to apply a DDM:
  1. Estimate expected future dividends per share
  2. Determine required rate of return (discount rate) based on stock's risk
  3. Calculate present value of each future dividend using discount rate
  4. Sum present values of all future dividends to obtain intrinsic value of stock

Constant growth model and assumptions

• Constant growth DDM (Gordon Growth Model) assumes company's dividends grow at constant rate indefinitely
  • Model represented by formula: $P_0 = \frac{D_1}{r - g}$
    • $P_0$: current stock price
    • $D_1$: expected dividend per share in next period
    • $r$: required rate of return (discount rate)
    • $g$: constant growth rate of dividends
• Key assumptions of constant growth DDM:
  • Dividends grow at constant rate forever
  • Required rate of return greater than dividend growth rate ($r > g$)
  • Company has stable dividend policy and expected to continue paying dividends (Coca-Cola, Johnson & Johnson)
  • Consistent dividend payout ratio over time

Strengths vs weaknesses of models

• Strengths of DDMs:
  • Provide straightforward way to estimate intrinsic value of stock based on expected cash flows
  • Can compare relative attractiveness of different dividend-paying stocks (utilities, REITs)
  • Constant growth DDM simple to use and requires few inputs
• Weaknesses of DDMs:
  • Rely heavily on accuracy of dividend growth rate estimates, which can be difficult to predict
  • May not be suitable for companies that do not pay dividends or have inconsistent policies (growth stocks)
  • Constant growth DDM assumes single, constant growth rate forever, which may not be realistic
  • DDMs do not account for non-dividend sources of value (retained earnings, potential M&A)

Stock price calculation methods

• Two-stage DDM:
  • Assumes company will experience high dividend growth for limited period, followed by lower, stable growth rate
  • Model represented by formula: $P_0 = \sum_{t=1}^n \frac{D_t}{(1+r)^t} + \frac{P_n}{(1+r)^n}$
    • $P_0$: current stock price
    • $D_t$: expected dividend per share in year $t$
    • $r$: required rate of return (discount rate)
    • $n$: number of years of high growth
    • $P_n$: terminal value of stock at end of high growth period, calculated using constant growth DDM
• Three-stage DDM:
  • Assumes company will experience high growth, followed by transition period of declining growth, then final period of stable growth
  • Model is extension of two-stage DDM, with additional stage for transition period (Microsoft, Apple)

Impact of variables on valuations

• Dividend growth rate:
  • Increase in dividend growth rate leads to higher stock valuation, all else equal
  • Decrease in dividend growth rate leads to lower stock valuation
• Required rate of return (discount rate):
  • Increase in required rate of return leads to lower stock valuation, all else equal
    • Future dividends discounted at higher rate, resulting in lower present values
  • Decrease in required rate of return leads to higher stock valuation
• Sensitivity analysis:
  • Important to perform sensitivity analysis by varying growth rates and required returns
  • Understand potential range of stock valuations
  • Assess impact of estimation errors and changes in market conditions on intrinsic value of stock (recession, interest rate changes)

Key Valuation Concepts

• Time value of money: Fundamental principle in DDMs, as future dividends are discounted to present value
• Equity risk premium: Incorporated into the required rate of return, reflecting additional compensation for stock market risk
• Dividend yield: Ratio of dividends to stock price, used to assess income potential and compare dividend-paying stocks