Investing With the Dividend Discount Model

Daniel Penzing
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How the Dividend Discount Model Works

The dividend discount model is a financial analysis that is used often for intrinsic valuation of stocks. It is a relatively simple model that makes use of the dividend payments that the company makes and arrives at a value for the stock.

In the dividend discount model, the dividend payments are taken into account as income to the business and is a form of return on investment.

The reason that this calculation is used so much in valuing stocks is that it tries to eliminate any other factors that might affect the return on investment. It is a model that involves looking at the dividends that are being paid by the company and making assumptions based on the calculated amount as to what they will be in the future.

In other words, the dividend discount model considers the expected dividends and not the expected share prices that the stock is likely to experience. The latter will be determined by other factors, such as market capitalisation or growth potential

The reason the dividend discount model is used so much is that it is a fairly simple analysis to perform. It is also relatively easy to determine what the company will be paying out in the future. As the dividends increase, the stock price will go up as well. In the end, it is a tool that helps you to calculate the stock price.

Price = Dividends ÷ (Rate of Return – Dividend Growth Rate)

Investing based on the dividend discount model is a great way to manage expectations and balance risk. If you watch investing videos, you’ll notice that this model is used across the board.

One of the reasons this is so popular is because it’s relatively easy to understand. There are three numbers that you need to be concerned with, and people generally understand the importance of each. This makes it very easy to put this model into practice.

The formula for this model is below:

The basics of this model should be fairly familiar to you. The first component is the price. This denotes the price of the stock per share. The next component is the dividends, which is the amount per share that the investor receives from the company.

The third component is the rate of return, which ensures that the investor makes their target amount by the time the investment matures. This means that the investor can sell their investment at fair value.

The final component is the dividend growth rate, which determines your return on investment. In the dividend discount model, this is the rate that drives the value of the investment. This is where you can see the most return.

Pros and Cons to Dividend Discount Models

While dividend discount models provide powerful analysis, they do have some drawbacks. One of the main cons is that the model doesn’t tell you when company earnings will change. It merely tells you what they will be.

If you are looking to buy stocks, this can be a problem. If you are just looking for the best stocks to invest in, then this won’t be a problem. You are simply interested in the best company that will allow you to send dividends to you.

Also, since the dividend discount models are based on accounting standards, they won’t take into account any of the accounting manipulations that some companies may employ.

They are also based on historical figures and can’t predict the future either.

Finally, there is no theorem or system in the model that tells you if the stock is under, over, or fairly valued. That is left up to you.

While these drawbacks are all negative, there are some more positive aspects of using dividend discount models. Their biggest advantage comes from the fact that they can be used to explain a company’s past and present conditions.