How Dividend Discount Models Can Be Used to Add Value

Abstract

A dividend discount model (DDM) is simply a formula for converting a stream of expected dividends into a present value, or price. DDMs add value in the investment process. The focus of this presentation is on how to use the DDM as a stock-picking tool. Figure 1 shows three different DDM formulations. The first represents the .generalized model, where projected dividends are discounted at a rate that corresponds to each time period in the future. While certainly comprehensive, this generalized form tends to be intractable, because the user must specify an infinite number of inputs.Under the assumptions that dividends grow at a constant rate G, and that the discount rate R is constant, the DDM reduces to the simple GordonShapiro model, as shown in Part 2 of Figure 1. But these assumptions are quite constraining, and the DDM is rendered less useful.Many practitioners use a three-stage DDM. This model is based on the assumption that the dividend stream of a company changes over the company's life cycle. Part 3 of Figure 1 illustrates a growth company. Dividends are assumed to grow quickly in the near term, followed by a slower, transitional rate of growth, and then level off at a slower growth rate during the mature stage.For the early growth stage, which is often assumed to last three to five years, explicit dividend estimates are made.