Summary:
Dividend Discount Models (DDM), also known as Gordon Growth Models (GGM), are used to value public equity (stock) based on the present value of future cash flows
There are 3 necessary inputs to utilize the DDM/GGM
If the value calculated from the DDM/GGM is higher than the current trading value, the stock is undervalued
Pro Forma Models has an institutional-quality and affordable prebuilt Dividend Discount Equity Valuation Model
Definition:
Dividend Discount Models (DDM), also known as Gordon Growth Models (GGM), are used to value public equity (stock) based on the present value of future cash flows. The model requires input for:
Dividend
Expected future growth rate
Cost of equity
Inputs:
Dividend Discount Model (DDM)/Gordon Growth Model (GGM) inputs can be calculated in the following manner:
Dividend: Current dividend can be calculated as the product of earnings per share and the dividend pay out ratio.
Expected Future Growth Rate: You will need to formulate future dividend expectations to utilize the model. The most common method is to apply a growth rate percentage to the current dividend. Another methodology is to observe historical dividends for patterns in incremental increases/decreases that can be applied to future expectations.
Cost of Equity: A company's cost of equity represents the compensation equity investors require for bearing the risk of ownership. A common method for estimating the cost of equity is to apply the capital asset pricing model (CAPM). The cost of equity is a key input into the model as it will serve as the discount rate for cash flows.
Interpretation:
Operating profits will typically result in dividends to shareholders (equity investors). Dividend Discount Models (DDM)/Gordon Growth Models (GGM) will calculate a fair value of a stock based on the present value of the future dividend cash flows. If the value calculated from the DDM/GGM is higher than the current trading value, the stock is undervalued. If the value calculated from the DDM/GGM is lower than the current trading value, the stock is overvalued.
Methodologies:
There are two Dividend Discount Models (DDM)/Gordon Growth Models (GGM) commonly used to value dividend paying equities. The two models are:
1. Single Stage Dividend Discount Model: Assumes a company exists in perpetuity and that there is constant growth in dividends. The model works by taking an infinite series of dividends and discounting them back to the present value based on the discount rate utilized. The formula for the single stage dividend discount model is:
2. Two Stage Dividend Discount Model: Assumes dividends will go through 2 stages of growth. The first stage involves the dividend growing at a constant rate throughout the time period. The second stage dividend is assumed to grow at a stable rate for the remainder of the company's life. The second stage of the model is the same as the single stage model, but includes the initial growth phase in the calculation. The formula for the two stage dividend discount model is:
Limitations:
The Dividend Discount Model (DDM)/Gordon Growth Model (GGM) has a 2 main short comings. The two shortcomings are:
1. Dividend growth is assumed in perpetuity, which makes it challenging to apply o companies with fluctuating dividends and near impossible to apply to companies with no dividend without substantial financial adjustments and assumptions.
2. Like most equity valuation models, the DDM/GGM is highly sensitive to inputs. Play around with the growth and discount assumptions or refer to the sensitivity tables in the Pro Forma Models Dividend Discount Equity Valuation Model to see how small changes in inputs can drastically change the output value.
Example:
Acme Company pays a cash dividend of $1.00 per share in the current year. Analysts expect dividends to grow at 3.00% per year and CAPM reflects a 6.00% cost of capital. Based on this information, we have the following inputs:
D0 = $1.00
g = 3.00%
D1 = D0 x (1+g) = $1.00 x (1+.03) = $1.03
r = 6.00%
DDM: D1 / (r-g) = $1.03 / (.06 - .03) = $34.33
Acme Company's stock is currently trading at $30.00, meaning the stock is undervalued and would be considered a buy based on the forward looking valuation assumptions.
Pro Forma Models:
Pro Forma Models has a team of highly educated staff (CFA Charterholders and MBA graduates) with institutional investment experience. The Pro Forma Models Dividend Discount Equity Valuation Model is prebuilt with:
Single Stage Dividend Discount/Gordon Growth Model with cost of equity as a direct input
Single Stage Dividend Discount/Gordon Growth Model with cost of equity calculated utilizing the capital asset pricing model (CAPM)
Single Stage Dividend Discount/Gordon Growth Model with cost of equity calculated using the dividend capitalization model
Two Stage Dividend Discount/Gordon Growth Model with cost of equity calculated utilizing the capital asset pricing model (CAPM)
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