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Finance: What is the Dividend Discount Model? 2 Views


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What is the Dividend Discount Model? Valuation of stocks can take numerous forms. One way in which one perspective on undervalued stocks is determined is by use of the Dividend Discount Model. Applying this method involves calculating dividends and expected dividend growth rates from the cost of equity to determine a stock’s current value and whether or not the current market price is discounted or at a premium to that value calculation.

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Transcript

00:00

Finance allah shmoop what is the dividend discount model Well

00:07

it's a technique used to value companies or at least

00:11

it wass in the stone age And yet in the

00:14

nineteen fifties maybe which basically says that a company's value

00:17

is fully contained in the cash dividends it distributes back

00:22

to invest doors This model is only useful really for

00:25

its historical relevance We we just don't use that much

00:28

these days Yeah back in the old timey cave man

00:30

days when there was essentially no research of real merit

00:33

being done on the performance of investments of whatever flavor

00:37

the dividend discount model was the best thing investors had

00:40

to value an investment in a company And remember in

00:43

those days companies paid rial dividends that were a meaningful

00:46

percentage of the total value of the company Unless so

00:50

a company pays a dollar a share this year in

00:53

dividends Historically it's raised dividends at about three percent a

00:58

year like paid a dollar last you'd expect two dollars

01:00

three next year in dollars six and change the next

01:02

so well The dividend discount model discounts backto present value

01:06

And yes we have an opus on what president value

01:08

Means but here's the logline definition present value of all

01:12

future cash flows discounted for risk in time Back to

01:15

cars Yeah that thing well a few odd things are

01:18

worth noting in this horse and buggy era formula The

01:21

dividend discount model ignores the terminal or end value of

01:25

the company Like say twenty years from now the company

01:28

is sold for cash The dividends are all that are

01:31

really focused on though in our model that seem strange

01:34

to you Well maybe But let's say the discount rate

01:37

is ten percent in the risk free rate is four

01:40

percent for a total of fourteen percent a year discounted

01:43

back to the present So doing the math just looking

01:45

at the terminal value of say a hundred million bucks

01:47

in a sale to be made twenty years from now

01:50

Let's figure out what that's worth today Well you take

01:52

the one point one four Put it to the twentieth

01:54

power to reflect twenty years of discounted valuation compounding And

01:58

you say one point one four forty twenty powers about

02:01

thirteen point seven So to get the present value of

02:04

one hundred million bucks twenty years from now using this

02:08

discount rate Will you divide the hundred million by thirteen

02:11

point seven and that means that the one hundred million

02:13

dollars twenty years from now today is worth only seven

02:16

point three million bucks And yeah that's ah big haircut

02:20

kind of like this guy Well the formula focuses ah

02:23

lot on near term dividend distribution and it's Really more

02:27

interesting is a relic of original financial research in theory

02:30

than anything directly useful today And if you find this

02:33

interesting while then we may have a gig for you

02:36

here at shmoop finance central Yeah come on down We 00:02:39.715 --> [endTime] need writers good ones not like me

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