vidend will grow by 3% annually. The company’s value should then be $1.00 / (.05 – .03) = $50.00. Here is the formula for valuing a company with a constantly growing dividend, as well as the proof of the formula:
Constant Growth : Po = Div/r-g
P0 = Div1/1+r + Div1 (1+g)/(1+r )^2 +………Div/r-g
The classic dividend discount model works best when valuing a mature company that pays a hefty portion of its earnings as dividends, such as a utility company.
Assumptions – The Problem of Forecasting
Proponents of the dividend discount model say that only future cash dividends can give you a reliable estimate of a company’s intrinsic value. Buying a stock for any other reason–say, paying 20 times the company’s earnings today because somebody will pay 30 times tomorrow–is mere speculation.
In truth, the dividend discount model requires an enormous amount of “speculation” in trying to forecast future dividends. Even when you apply it to steady, reliable, dividend-paying companies, you still need to make plenty of assumptions about their future. The model is subject to the axiom “garbage in, garbage out,” meaning that a model is only as good as the assumptions it is based upon. Furthermore, the inputs that produce valuations are always changing and susceptible to error.
The first big assumption that the DDM makes is that dividends are steady, or grow at a constant rate indefinitely. But even for steady, reliable, utility-type stocks, it can be tricky to forecast exactly what the dividend payment will be next year, never mind a dozen years from now.
To get around the problem posed by un-steady dividends, multi-stage models take the DDM a step closer to reality by assuming that the company will experience differing growth phases. Stock analysts build complex forecast models with many phases of differing growth to better reflect real prospects. For example, a multi-stage DDM may predict that a company will have a dividend that grows at 5% for seven years, 3% for the following three years and then at 2% in perpetuity.
However, such an approach brings even more assumptions into the model–although it doesn’t assume that a dividend will grow at a constant rate, it must guess when and by how much a dividend will change over time.
What Should Be “Expected“?
Another sticking point with the DDM is that no one really knows for certain the appropriate expected rate of return to use. It’s not always wise simply to use the long-term interest rate because the appropriateness of this can change.
The High-Growth Problem
No fancy DDM model is able to solve the problem of high-growth stocks. If the company’s dividend growth rate exceeds the expected return rate, you cannot calculate a value–because you get a negative denominator in the formula. Stocks don’t have a negative value. Consider a company with a dividend growing at 20% while the expected return rate is only 5%: in the denominator (r-g) you would have -15% (5%-20%)!
In fact, even if the growth rate does not exceed the expected return rate, Growth stocks, which don’t pay dividends, are even tougher to value using this model. If you hope to value a growth stock with the dividend discount model, your valuation will be based on nothing more than guesses about the company’s future profits and dividend policy decisions. Most growth stocks don’t pay out dividends. Rather, they re-invest earnings into the company with the hopes of providing shareholders with returns by means of a higher share price.
Consider Microsoft, which didn’t pay a dividend for decades. Given this fact, the model might suggest the company was worthless at that time–which is completely absurd. Remember, only about a third of all public companies bother to pay dividends. Furthermore, even companies that do offer payouts are allocating less and less of their earnings to shareholders.
The dividend discount model is by no means the be-all and end-all for valuation. That being said, learning about the dividend discount model does encourage thinking. It forces investors to evaluate different assumptions about growth and future prospects. I