Dividend Discount Model: A Simple Three Step Guide To Valuation

In our quest to find the intrinsic value of stocks that we are interested in investing in, we have looked at several different types of formulas to help us determine that value. We haven’t considered the role that dividends play in these valuations, and as dividend investors, this is an important fact to factor in. Today we will discuss the dividend discount model to find the intrinsic value of dividend paying stocks.

Dividends are such an important variable to building our wealth, it is in our best interests to continue to add to our toolbox the different methods of calculating intrinsic value. The dividend discount model is simplicity itself and requires only three inputs to determine the value of a stock.

As we continue to strive to find the fair value of any stock that we wish to purchase, it is important to remember that the calculations that we do should never replace other methods of investigation, such as reading the 10-k, looking into other metrics, and doing our research.

In our efforts to narrow down our investing processes and learn more about different formulas to help us find intrinsic value, it is important to remember that we should try not to go down the rabbit hole in search of minutiae. A thought from Warren Buffett on intrinsic value.

“It’s better to be approximately right, than precisely wrong.”

That being said, we should strive to be as accurate as we can, to help narrow down our errors in finding intrinsic value.

Dividend Discount Model Definition

So what is a dividend discount model?

The dividend discount model (DDM) is a procedure for valuing the price of a stock by using the predicted dividends and discounting them back to the present value. If the value obtained from the DDM is higher than what the shares are currently trading at, then the stock is undervalued.

One thing to keep in mind when utilizing this formula is the fact that it won’t work for a company that doesn’t pay a dividend. So, companies like Tesla, Netflix, Facebook, Amazon, and Alphabet wouldn’t work with this formula.

Dividend Discount Model Formula

This formula is as follows:

Fair Value = Next year’s expected dividend/discount rate – growth rate

The formula is calculated as follows. It is next year’s expected dividend divided by an appropriate discount rate subtracted from the expected growth rate.

Or:  P  =  D / r – g

This requires three inputs to calculate the formula

How the dividend discount model works is the model works off the idea that the fair value of an asset is the sum of its future cash flows discounted back to fair value with an appropriate discount rate.

Dividends are future cash flows for investors.

This particular model is also known as the Gordon Growth model and it was created by Myron Gordon and Eli Shapiro at the University of Toronto in 1956.

Today we will use the Gordon Growth model to calculate the intrinsic value of our examples. I have chosen to use this formula today as it is a little easier to calculate and we can use it for our more stable, mature companies.

For our first example, I will use Coca-Cola (KO) as they are, to me, a very stable, mature company and should be a fine example of how this formula could work. Remember that we are trying to be approximately correct.