Price is what we pay and value is what we get; so, the only way we can invest in an intelligent and disciplined manner is to know the difference between the price and value. Here we venture into our first valuation model of this series, the Dividend Discount Valuation. If you haven’t had a chance, read the introduction to valuation before reading this.
The primary question for every investment is: What is the return? If you learn how to answer this question for yourself it frees you from a dependence on what others think. It also gives you a basis for evaluating the information you do receive from others. Here, we take the first step in freeing us from dependency on others about how we invest our hard-earned money.
The best way to value a business is most often a Discounted Cash Flow (DCF) analysis. This tool supports our investment decisions with a quantitative valuation. The Dividend Discount Model (DDM) is one of the discounted cash flow models we can use—keep reading to learn how.
The Dividend Discount Model’s focus is on the most direct form of cash flow from the investors perspective: the dividends paid directly to shareholders. It is a discounted cash flow tool based on the idea that an investment is worth the present value of the future dividend payments.
Dividend Discount Model
The DDM is conservative, because the value is based on the dividends. Dividends are real payments made directly to shareholders and are unambiguous. The dividend checks deposited into your account are not subject to accounting interpretations.
The choice of the discounted cash flow model used for valuation is based on the company’s characteristics. We use the DDM to value companies with a history of stable dividends, therefore often mature companies.
The assumption that the company will continue with their dividend policy into the future is built into the DDM. This is because the DDM determines the value of a stock on the sum of the net present value (NPV) of all the expected future dividend payments.
The discount rate is the minimum return required from an investment. It can be based on prevailing interest rates, inflation or other variables.
In the case of the Dividend Discount Model, it’s easy to think of the discount rate as the “opportunity cost” you forgo if you choose another investment. For example, the opportunity cost (discount rate) would be 5% if the alternative is to buy a bond earning 5% interest per year. It’s what we give up by not buying the bond to buy the dividend-paying stock. The opportunity cost or discount rate would be 10% if an alternative investment would earn 10% per year.
The purpose of discounting future dividend payments is to determine today’s (present) value of the future payments. We can then compare the future payments in today’s dollars to the cost of the investment in today’s dollars. We get an apple-to-apple comparison that considers the time value of money.
Different Dividend Growth Rates
The Dividend Discount Model has two versions based on the anticipated dividend growth. The constant dividend growth rate model, also referred to as the Gordon Growth Model, and the multi stage growth model.
Constant Growth Rate Model (Gordon Growth Model)
This model assumes that the dividend grows at a constant rate forever (in perpetuity). Although this may not be a realistic assumption in many cases, it is useful for calculating a terminal value and to illustrate discounting.
Constant Growth Rate Model Formula
The present value of future cash flows (in this case dividend payments) is the intrinsic value. The dividend discount formula determines the present value (or intrinsic value) of a constantly growing dividend (in perpetuity):
- D1 = dividend per share received at the end of first year
- r = the discount rate or required return (in this case the opportunity cost)
- g = the expected dividend growth rate
Investopedia explains the proof of this simple formula for those interested in learning more about it.
Example of the Constant Dividend Growth Rate Model
The multiple-stage growth rate model, which we’ll discuss in the next post, was used in the post on Brookfield Infrastructure Partners (BIP). Here, I use the same assumptions; a 10% discount rate, $1.74/share 2017 dividend, except the growth rate is constant at 7%:
BIP’s Present Value (PV0) at a Constant 7% Growth:
In this estimate, the 7% midpoint dividend growth rate continues forever and results in an intrinsic value of $58.00 per share. Go ahead and try it yourself, did you get the same answer?
The multi-stage growth rate model used in the BIP valuation post shows the value at $36 per share; quite a difference from the $58 value determined here. So obviously, our assumptions can dramatically change the outcome of our valuations. More on this later.
In this case, since the intrinsic value of $58 per share is higher than the price of $35 per share, the investment appears to be very attractive. It will generate a positive return well above our 10% required rate of return.
It also illustrates an important point; that the assumptions you make in a valuation can greatly affects the numbers you’ll generate.
In the next post, we’ll go into the Multi Stage Dividend Growth Rate Model so you can learn how to use it for your valuations.
The Fine Print:
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