The dividend discount model (DDM) is a valuation model that calculates the present value of a company's future dividends. This model is used to find attractive dividend stock investment opportunities. This blog post will discuss how to use the DDM to find high-quality dividend stocks. We will also provide a step-by-step example so you can see how it works!
What is the dividend discount model, and how does it work?
The dividend discount model is a financial valuation model that calculates the present value of a company's future dividends. The model is based on the premise that a stock's price equals the present value of all its future dividend payments. In other words, the DDM tells us whether a stock is undervalued or overvalued based on its expected future dividend payments.
The dividend discount model is a relatively simple model to understand and use.
Dividend discount formula model formula: P = D / (r-g)
P = stock price
D = expected dividends per share
r = discount rate
g = dividend growth rate
Let's break down each component of the formula.
Dividend per share (D)
This is the most critical input in the dividend discount model. The dividend per share is the amount of money that a company pays out to its shareholders for each share. You can find a company's dividend per share by looking at its financial statements or by using a tool like Wisesheets, which automatically retrieves it on your spreadsheet (see free spreadsheet template below).
Discount rate (r)
The discount rate is the rate of return that investors require to invest in a company. This rate is typically equal to the investor's required rate of return. This number can be obtained by looking at the current risk-free rate by typing "10-year treasury rate on Google" and adding an interest rate premium based on the level of risk that the company has in its market and operations. For example, companies like Coca-Cola and Walmart, who have paid dividends consistently over decades and are market leaders, tend to be discounted at lower rates than riskier companies.
Dividend growth rate (g)
The dividend growth rate is the percentage by which a company's dividends are expected to grow each year. This rate is typically estimated using a company's historical dividend growth rate.
Dividend Growth Rate = (latest dividend – previous dividend) / previous dividend
This calculation is repeated for several years, and then typically, an average of the dividend growth rate over time is used.
Now that we understand the basics of the dividend discount model, let's look at how it can be used to find attractive dividend stock investment opportunities.
How to use the dividend discount model to find attractive dividend stocks
There are two ways to use the DDM model. The first way is to find companies with a higher dividend yield than the discount rate. This means that the company's dividend payments are expected to exceed the required rate of return and thus be profitable dividend investments. In simple terms, if you want to achieve a 5% return and the yield is 6%, then you know that this investment meets the criteria.
The second way is to find companies whose stock price is trading below the present value of its future dividend payments. This means that the company is undervalued based on its expected future dividend payments and therefore represents an attractive buying opportunity where you can buy a stock worth $1 dollar for $0.80 as an example.
To find these companies, you can use a tool like Wisesheets, which allows you to screen for stocks using the dividend discount model right on your Excel and Google Sheets spreadsheet (see free spreadsheet template below).
Once you have found some companies that look attractive, you will need to do some further research to determine if they are indeed suitable investments. This research should include an analysis of the company's financial statements, competitive position, and management team. Check out this article for more information.
Free dividend discount model template
To help you get started, we've created a free dividend discount model template that you can use on your own Excel or Google Sheets spreadsheet. This template includes the dividend discount model formula and allows you to input a company's data to find its intrinsic value.
You can access the free template by clicking here.
With this template, you can change the ticker and automatically get the company's history of dividend payments, and historical dividend growth. This allows you to easily change the required rate of return to assess how much you should pay for a particular dividend stock. At this time, it allows you to screen for dividend stocks where the dividend yield is higher than the required rate of return.
Altogether this represents a powerful tool to give you an edge when looking at many dividend stocks and save you countless hours of time getting the data and making calculations.
*Note in order to take advantage of this template, you need a Wisesheets account to get the dividend data on your spreadsheet. You can get your free account here.
Examples of how to use the dividend discount model to find attractive dividend stocks
Now that we have seen how to use the dividend discount model, let's take a look at some examples of how it can be used to find attractive dividend stocks.
Coca Cola DDM value
In this example, you can see that with a required 5% return and using the 5-year dividend growth average, Coca-Cola's stock is worth $5 per share. Therefore at the current price of $496.42 per share, it is not worth buying the stock based on this singular type of analysis. Calculating the value of dividend stocks in this way allows you to buy the companies that fit your criteria and are undervalued. Alternatively, you can keep them in your watchlist along with a target price (see free watchlist template).
The benefits of using the dividend discount model to find attractive dividend stocks
The DDM is a powerful tool that can be used to find attractive dividend stocks. It allows you to screen for companies based on their dividend yield and/or their stock price being below the present value of its future dividend payments. This type of analysis should be part of your due diligence when researching new dividend stocks to buy.
In addition, the dividend discount model can be used to monitor your existing dividend stocks. By regularly updating the intrinsic value of your stocks, you can sell when they are overvalued and buy when they are undervalued. This will help you maximize your returns and minimize your risk.
Lastly, the dividend discount model is a great way to keep track of your dividend stock watchlist. By inputting the data for each company into the template, you can easily see which stocks are undervalued and worth further research.
Drawbacks of using the DDM
While the dividend discount model is a powerful tool, it does have some drawbacks. One of the biggest drawbacks is that it relies on future dividend payments. This means that if a company cuts its dividend, the intrinsic value will be significantly lower than what it was previously.
Another drawback is that the model does not consider other factors that can affect a company's stock price. For example, if a company announces a new product that is expected to be a big success, the stock price will likely increase even if the dividend remains the same.
Lastly, it is a simplified way of valuing a company. This means that it will not always be accurate and should be used in conjunction with other valuation methods.
Despite its drawbacks, the dividend discount model is a valuable tool that can be used to find attractive dividend stocks. With its easy-to-use template, you can save time and effort when researching new stocks. In addition, by regularly updating the intrinsic value of your stocks, you can monitor your portfolio for overvalued and undervalued stocks.
What do you think about the dividend discount model? Do you use it to find attractive dividend stocks?
The Wisesheets Team