Dividend Discount Model (DDM) for Stock Prices

DDM - Applicability: Pretty easy to incorporate stock buybacks (Modified Payout Ratio).

Modified Payout Ratio = (Dividends + Buybacks - LT Debt Issues)/Earnings

Dividend Discount Model (DDM) for Stock Prices:

We can use present value of discounted cash flows.

DDM - Applicability: Useful in 3 Scenarios

1) Establishes a baseline/floor value for firms with economic cash flows exceeding dividends. Cash not paid out is frequently wasted on poor investments/acquisitions. 2) Realistic estimates for firms that on average pay out their cash flows. Firms with stable earnings, in mature businesses. Until recently, regulated utilities (phone/power) were a good example. 3) In sectors where estimating economic cash flows is difficult, dividends are the only cash flow that can be estimated precisely. Think financial services.

What are the cash flows to an investor from buying and holding a share of stock until time T?

D1, D2, D3, ..., DT, PT (Dt = dividend at time t)

DDM - Bottom Line: Limitations (2 of them)

Limitations: 1) Many firms retain cash instead of paying it out. In the DDM, we abandon equity claims to cash balances. Undervalue firms with large/increasing cash balances. 2) Other firms pay too high dividends (draw down cash balances); not sustainable. Overvalue these firms with DDM.

If the opportunity cost of capital (cost of equity capital) on this asset is (r), then the present value is:

P0 = D1/(1 + r) + D2/(1 + r)^2 + D3/(1 + r)^3 + ... + DT/(1 + r)^T + PT/(1 + r)^T

But the same type of analysis will hold at time:

PT = (DT + 1/(1 + r)^1) + (DT + 2/(1 + r)^2) + (DT + 3/(1 + r)^3) + ...

DDM - Bottom Line: Strengths (3 of them)

Strengths: 1) Simplicity, intuitive logic. Dividends are the main cash flow. Ex: Microsoft. 2) Need fewer assumptions. Instead of predicting firm cash flows (capex, depreciation, working capital), we are predicting dividends (observe last year's dividends + predict growth rate). 3) Managers try to pick sustainable dividend levels. Dividends are stable (smoothed).

Plugging this formula for PT into the original equation gives:

∞ P0 = Σ Dt/(1 + r)^t t=1 Note: Our derivation shows that this formula does not assume the stockholder will hold the stock forever even though it's an infinite sum.

Calculating expected return (annual):

⟹ Expected Return = (D1 + P1 - P0)/P0 = r Expected Return = D1/P0 + (P1 - P0)/P0 D1/P0 = "Dividend Yield" (prospective), (P1 - P0)/P0 = Capital Gain Expected Return on Equity = Prospective Dividend Yield + Expected Capital Gain If dividends are constant over time: P0 = D̄/r ⟹ r = D̄/P0 = Dividend Yield