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Dividend Discount Models

Used to predict the value of a company's stock based on the theory that its present-day value is the sum of all its future dividend payments, discounted back to their present value.

Simple Dividend Discount Model

Used to estimate the value of companies that have reached maturity and pay stable dividends as a significant percentage of their Free Cash Flow to Equity, with little to no high-growth potential.

Estimated Value = Expected Dividend / (Discount Rate (%) - Growth In Perpetuity (%))

This is also known as the Gordon Growth formula, which assumes that the expected dividend growth rate in perpetuity is constant.

This model was inspired by Prof. Aswath Damodaran's spreadsheet ddmst.xls

Expected Dividend:

  • The expected dividend for the next year.
  • It is calculated by taking the average between Next Linear Regression Dividend and the last twelve months of dividends LTM Dividend.

Expected Dividend = (Next Linear Regression Dividend + LTM Dividend) / 2

Growth In Perpetuity (%):

  • This is the expected perpetual growth rate of dividends.
  • By default, it equals the current yield of the U.S. 10-Year Treasury Bond.

Two-Stage Dividend Discount Model

Used to estimate the value of companies experiencing two growth stages: an initial High Growth Period represented by Sum of Discounted Dividends, followed by a Stable Growth Period represented by Discounted Terminal Value.

Estimated Value = Sum of Discounted Dividends + Discounted Terminal Value

This model was inspired by Prof. Aswath Damodaran's spreadsheet ddm2st.xls

The First Stage (High Growth Period)

In this stage, we estimate future dividends during the high-growth period, calculated as a percentage of forecasted EPS (Earnings Per Share), then discount them to present value.
EPS is projected using a linear regression of past EPS and the Average Historical Dividend Growth Rate.
We use dividend growth over EPS growth because dividends tend to grow more consistently.

Sum of Discounted Dividends = Dividend(t+1)/(1 + Discount Rate (%)) + Dividend(t+2)/(1 + Discount Rate (%))^2 + ... + Dividend(t+High Growth Years)/(1 + Discount Rate (%))^High Growth Years

High Growth Years:

  • The number of years expected to experience high growth.

High Growth Rate (%):

  • The expected EPS growth rate during the high-growth period.
  • By default, this equals the Average Historical Dividend Growth Rate.

High Growth Payout (%):

  • The expected dividend payout ratio during the high-growth phase.

The Second Stage (Stable Period)

In this stage, we estimate a terminal value at the end of the high-growth phase and discount it to present value.

Terminal Value = EPS in Stable Phase * Stable Payout / (Discount Rate - Stable Growth In Perpetuity)
Discounted Terminal Value = Terminal Value / (1 + Discount Rate)^High Growth Years

Stable Growth In Perpetuity (%):

  • The expected perpetual growth rate of dividends and EPS.
  • By default, this equals the current yield of the U.S. 10-Year Treasury Bond.

Stable Payout:

  • The dividend payout ratio in the stable phase, expressed as a percentage of EPS.

Stable Payout = 1 - Stable Growth In Perpetuity / Average Historical Return on Equity

Return on equity is calculated as: Net Income / Equity

Expanded:

Stable Payout = (Net Income - Stable Growth In Perpetuity * Equity) / Net Income

Here, Stable Growth In Perpetuity * Equity gives a rough estimate of the minimum retained earnings during the stable phase.

Discount Rate (Cost of Equity)

Discount Rate:

  • Used to discount all future dividends during the high-growth period and the terminal value in the stable phase.
  • By default, it is calculated using the cost of equity formula:

Discount Rate = Risk Free Rate + Beta * Market Premium

Beta:

  • A numeric value that measures the stock's volatility relative to the overall market.

Risk Free Rate (%):

  • By default, this is equal to the current yield of the U.S. 10-Year Treasury Bond.

Market Premium (%):

  • Typically uses the U.S. market average of 5.5%.
  • Defined as the average market return minus the average risk-free rate.

Calculating Historical Table Values

Some companies have preferred shares that receive dividends, so they must be accounted for when calculating net income and dividends available to common shareholders.

Common Dividends (t) = Dividends per share (t) * Shares Outstanding (t)

Return on Equity (t) = Net Income (t) / Equity (t-1)

Payout Ratio (t) = Common Dividends (t) / Net Income (t)

Dividend Yield (t) = Dividends per share (t) / Reference market price (t)