Discounted Dividend vs. Corporate Valuation

Earlier, we discussed the need for management to make decisions that improve the firm's financial performance. The dividends paid and the potential for future dividends are indicators of performance. After you read, you will be able to explain the dividend discount model and how it is used in stock valuations.

The dividend discount model values a firm at the discounted sum of all of its future dividends, and does not factor in income or assets.

Learning Objectives

Calculate a company's stock price using the discounted dividend formula

Key Takeaways

P = D1 / ( r – g ). P is the current stock price, g is the constant growth rate in perpetuity expected for the dividends, r is the constant cost of equity for that company, and D1 is the value of the next year's dividends.
The equation can also be understood to generate the value of a stock such that the sum of its dividend yield (income) plus its growth ( capital gains ) equals the investor ‘s required total return.
There are also problems with the model, such as the presumption of a steady and perpetual growth rate less than the cost of capital may not be reasonable.

Key Terms

Miller-Modigliani hypothesis: The Modigliani–Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process (the classical random walk), in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed.

The dividend discount model (DDM) is a way of valuing a company based on the theory that a stock is worth the discounted sum of all of its future dividend payments. In other words, it is used to value stocks based on the net present value of the future dividends. The equation most always used is called the "Gordon Growth Model." It is named after Myron J. Gordon who originally published it in 1959, although the theoretical underpin was provided by John Burr Williams in his 1938 text The Theory of Investment Value.

The variables and equation are:

P is the current stock price.
g is the constant growth rate in perpetuity expected for the dividends.
r is the constant cost of equity for that company.
D1 is the value of the next year's dividends.
There is no reason to use a calculation of next year's dividend using the current dividend and the growth rate, when management commonly disclose the future year's dividend, and websites post it.

$P = \dfrac{D_{1}}{r-g}$

Income plus capital gains equals total return.

The equation can also be understood to generate the value of a stock such that the sum of its dividend yield (income) plus its growth (capital gains) equals the investor's required total return. Consider the dividend growth rate as a proxy for the growth of earnings and by extension the stock price and capital gains. Consider the company's cost of equity capital as a proxy for the investor's required total return.

Income + Capital Gain = Total Return

Dividend Yield + Growth = Cost of Equity

$\dfrac{D}{P} + g = r$

$\dfrac{D}{P} = r - g$

$\dfrac{D}{r-g} = P$

Problems with the Model

a) The presumption of a steady and perpetual growth rate less than the cost of capital may not be reasonable.
b) If the stock does not currently pay a dividend, like many growth stocks, more general versions of the discounted dividend model must be used to value the stock. One common technique is to assume that the Miller-Modigliani hypothesis of dividend irrelevance is true and, therefore, replace the stock's dividend D with E earnings per share. However, this requires the use of earnings growth rather than dividend growth, which might be different.
c) The stock price resulting from the Gordon model is hypersensitive to the growth rate chosen.

Source: Boundless.
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Last modified: Thursday, August 25, 2022, 5:57 PM