One of the problems that investors face in the stock market is figuring out the value of the stocks in which they are considering investing. Comparing a stock’s value to its market price allows investors to determine if a share of stock is being traded at a price that is greater or less than its actual value. There are a variety of ways that investors attempt to value stocks, but one of the oldest and most basic is the dividend discount model.

The dividend discount valuation model uses future dividends to predict the value of a share of stock, and is based on the premise that investors purchase stocks for the sole purpose of receiving dividends. In theory, there is a sound basis for the model, but it relies on a lot of assumptions. Nevertheless, it is still often used as a means to value stocks.

Let’s take a look at the theory behind the dividend discount model, how it works, and if and when you should use it to evaluate whether to purchase a stock.

## Theory and Process Behind the Valuation Model

Rational investors invest in securities to make money. The concept behind this model is that investors will purchase a stock that will reward them with future cash payments. Future dividend payments are used to determine how much the stock is worth today.

In order to use the model, investors must accomplish a few things:

### 1. Approximate future dividend payments

This is not always an easy task, because companies do not offer the same dividend payouts each year. Dividends are the shares of earnings that corporations choose to redistribute to their shareholders. Corporations vary these payments, but as a rule of thumb investors usually assume that corporations redistribute a given percentage of their earnings to their shareholders. Of course, this raises the additional challenge of forecasting future income, which is usually accomplished by forecasting growth or decline in sales and expenses over future years. Then they can calculate the amount of money that is expected to be paid out in the form of dividends and divide that by the number of shares outstanding to determine the amount of dividends each investor is paid for every share they own.

### 2. Determine a discount rate for future payments

Determining the value of a share of stock isn’t as simple as adding up all future dividend payments. Payments made in the near future are considerably more valuable than those made in later years due to the time value of money. Imagine that an investor plans to invest for a five year horizon. The payments he receives after the first year can be reinvested for four years, whereas the payments he receives after five years cannot be reinvested. Therefore, the payments he receives in one year are a lot more valuable. Investors need a method of discounting the value of these dividends. This is accomplished by determining a required rate of return for investors, which is usually assumed to be the amount of money they could earn investing in the stock market as a whole (usually approximated with the estimated return of the S&P index) or a combination of investing in stocks and bonds yielding the current rate of interest.

### 3. Apply the calculations for the model

The equation for the dividend discount model is:

In this model, P represents the present day value of the stock, Div represents the dividends that are paid out to investors in a given year, and r is the required rate of return that investors expect given the risk of the investment.

In addition, the value of a company whose dividend is growing at a perpetual constant rate is shown by the following function, where g is the constant growth rate the company’s dividends are expected to experience for the duration of the investment:

Using these two formulas in conjunction with one other, the dividend discount model provides for a straightforward technique to value a share of stock based on its expected future dividends.

## Example of the Dividend Discount Valuation Model

ABC Corporation is paying dividends of $2 per share. Investors expect a rate of return of 8% on their investment. Dividends are expected to grow by 5% for one year and then 3% each year thereafter. Applying the discount model using the two formulas above, the value of the investment can be calculated in each period:

**Year 1.**The value of the investment for this time frame is $2.00/1.08 = $1.85.**Year 2.**Dividends for this year have grown to $2.10 per share based on the 5% growth rate. The value of the investment for this period of time is expected to be worth $2.10/(1.08)^2 = $1.80**Constant growth value.**According to the constant growth equation listed above, the constant growth value of a share of stock is $2.10/(0.08-0.03)= $42.

**Value of a share of ABC Corporation.** The value of a share of stock is calculated by using the two formulas above to calculate the value of the dividends in each period: (2.00)/(1.08) + 2.10/(1.08)^2 + 2.10/(0.08 – 0.03) = $45.65 per share.

**Compare to a value of a current share of stock.** This is the most important part of the model. If a share of stock is trading at less than $45.65 per share, the stock is underpriced and they can profit by purchasing it. If the stock is trading at more than $45.65 per share, they may be able to profit by short selling the security.

## Advantages

There are three major reasons why the dividend discount model is a popular valuation technique:

**1. Simplicity of Calculations**

Once investors know the variables of the model, calculating the value of a share of stock is very straightforward. It only takes a little bit of algebra to calculate the price of stock.

**2. Sound and Logical Basis for the Model**

The model is based on the premise that investors purchase stocks so that they can get paid in the future. Even though there are a number of reasons that investors may purchase a security, this basis is correct. If investors never received a payment for their security it wouldn’t be worth anything.

**3. The Process Can Be Reversed to Determine Growth Rates Experts Predicted**

After looking at the price of a share of stock, investors can rearrange the process to determine the dividend growth rates that are expected for the company. This is useful if they know the predicted value of a share of stock but want to know what the expected dividends are.

## Disadvantages

Although many investors still use the model, it has become a lot less popular in recent years for a variety of reasons:

**1. Reflects Rationality, Not Reality**

The dividend discount model is based on the concept that investors invest in stocks that are most likely to pay them the most. Although this is the way that investors *should* behave, it does not always reflect the way investors *actually* behave. Many investors purchase stocks for reasons that have nothing to do with the company’s financial position or its future dividend payments. Some investors purchase a company that happens to be more glamorous or interesting. This often explains why there is a discrepancy between a stock’s intrinsic value and the actual market value.

**2. Difficulty Determining the Variables that Go into the Model**

The dividend discount model is simple to use. However, it is difficult to determine the numbers that go into it, which can yield inaccurate results. Companies are often unpredictable with their dividends, so forecasting them for this model is difficult. It is also very difficult to estimate the future sales of a company, which influences a corporation’s abilities to maintain or grow dividends.

**3. Dividends Aren’t the Only Way Earnings Have Value to Investors**

Investors may be primarily concerned with dividends, but all earnings are still owned by investors. Dividends only represent the share of earnings that a corporation chooses to pay out. Retained earnings are still owed to investors and still count towards their wealth. This is why newer models evaluate the overall cash flow of a company, not the amount that is paid back to investors.

**4. Investor Bias**

Investors have a tendency to confirm their own expectations. This means that most investors are going to come up with their own values for a stock since many of the inputs here are somewhat subjective. Only those who can force themselves to be objective are likely to find accurate variables for the model.

**5. Sensitive Valuation Model**

This model is very sensitive to small changes in input variables. Therefore, it can be easy to accidentally identify a security as being overpriced or underpriced if you are slightly off with your estimate of specific input.

**6. Useless for Valuing Stocks with No Current or Near-Future D ividend Payments**

As mentioned earlier, investors can only receive value from a company that will pay them dividends at some point. However, some companies don’t currently offer dividends at a given time and aren’t expected to in the near future. A decade ago, Microsoft had never paid a dividend, but was one of the most successful stocks ever. Investors knew the value behind the company and that they could receive dividends later on. However, the dividend discount model would have been a useless way to try to value the stock.

## Final Word

The dividend discount model is a logical and rational attempt to approximate the value of a company’s stock. In a simulated world, investing in a stock based solely on the value of their future dividends would be a perfect system.

Unfortunately, it is not always a reliable indicator in the real world. Investors are often irrational and variables are difficult to predict. These are challenges that all valuation models must contend with. Even if variables such as future dividends could be forecast accurately, it would still be impossible to know the true value of a share of stock in the market. However, investors must at least make an attempt to approximate a stock’s value before investing so that they can make an educated decision.

Have you used the dividend discount model to value a stock? What were some pros and cons based on your own personal experiences?