If you understand the concept of the time value of money, you will be interested in using dividend payouts to determine a company's stock value. You can do this through the Dividend Discount Model (DDM). 

Dividend payouts help you determine whether a stock is fairly priced, undervalued, or overvalued based on the present value of the projected future dividends.

What is the Dividend Discount Model (DDM) and How Does it Work?

The Dividend Discount Model (DDM) bases the value of a company's stock on the total present value of its future dividend payments. This model helps us determine if a stock is priced below or above its actual value by considering its anticipated dividends.

How can we discount future dividends to their present value? Which discount rate should we use? What about the criteria for projecting dividend payout?

First, let us look at the formula used to calculate the DDM of a particular stock:

Dividend discount formula model formula: P = D / (r-g)

where:

P = stock price

D = expected dividends per share

r = discount rate

g = dividend growth rate

Now, let's break down each component of the formula.

Dividend per share (D)

This is the most critical part of the dividend discount model. The dividend per share is the amount of money or the dividend that a company pays out to its shareholders for each share. 

You can find this amount (dividend per share) in the financial statements of the company or retrieve it automatically on your spreadsheet using a tool like Wisesheets (see free spreadsheet template below).

Discount rate (r)

The discount rate is the rate of return that investors require to invest in a company. Interestingly, this is typically equal to the investor's required rate of return. You can get this rate by looking at the current risk-free rate when you type "10-year treasury rate" on Google. 

This represents the rate that is free of risk. The more risk a company represents, higher will be its required rate of return. So adding an interest rate premium which represents the level of risk that the company has in its market and operations, you can get the premium rate.

For example, companies like Coca-Cola, Tesla, Amazon or Walmart have paid dividends consistently over decades and have strong market positions. So investors tend to discount them at lower rates than riskier companies.

Dividend growth rate (g)

The dividend growth rate shows the percentage by which a company's dividends are expected to grow each year. Analysts typically estimate this rate using the company's historical dividend growth rate.

Dividend Growth Rate = (latest dividend – previous dividend) / previous dividend

Analysts repeat this calculation for several years and then typically use an average of the dividend growth rate over time.

Now that we have covered the fundamentals of calculating the dividend discount model, let's explore how to use it to find attractive dividend stock investment opportunities.

Components of the Dividend Discount Model

Following are further explanations of the components of the Dividend Discount Model:

Discount Rate and the Time Value of Money

The Dividend Discount Model (DDM) is a model that values a stock by calculating the present value of its future dividends. The model is based on the concept of time value of money, which indicates that money's value changes over time. 

This means that due to inflation and opportunity costs, a dollar tomorrow is worth less than a dollar today. In DDM, the discount rate represents the investors' required rate of return or the minimum acceptable return. This rate is applied to discount future dividends to their present value.

Expected or Future Dividends

The model assumes that a stock's fair price is the sum of all its future dividends, discounted to their present value. The most commonly used DDM variation is the Gordon Growth Model, which assumes a constant dividend growth rate in perpetuity.

The DDM heavily depends on forecasting future dividends and their growth rate to determine the stock's intrinsic value. However, we must take into account that accurately predicting the projected dividends is difficult, hence it is a significant limitation of the model.

Dividend Growth Rate

There are two types of Dividend Growth Rate Models used:

Constant Dividend Growth Rate

The constant growth version of the DDM, known as the Gordon Growth Model, assumes that dividends will grow at a constant rate indefinitely. 

This model is typically applied to mature companies with a stable dividend payout history. The growth rate of dividends in this model, denoted as "G," represents the expected dividend growth rate.

Two-Stage Dividend Discount Model

Analysts use the two-stage DDM for companies expected to go through different growth phases.

It divides the forecast into three stages: a development growth stage, a maturity growth stage, and a terminal growth stage. The dividend growth rate changes across these stages, starting higher in the early stages and decreasing in the later stages.

How to use the Dividend Discount Model (DDM) to find Profitable Dividend Stocks

There are two scenarios that can arise when you use the DDM model. The first is that the company you have selected has a higher dividend yield than the discount rate. In this case, expect the company's dividend payments to exceed the required rate of return, making them profitable dividend investments.

For instance, consider a hypothetical company, Toys Unlimited. Assume that its dividend yield is 6%. Now, if your required rate of return is 5% return, then this investment will meet your criteria and you should invest.

The second scenario is that you have a hypothetical company, Newton's Veggies, whose stock price is trading below the present value of its future dividend payments. 

This means that consider the company undervalued based on its expected future dividend payments, representing an attractive buying opportunity where you can buy a stock worth $1 for $0.80.

To find similar companies in real life, 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.

The Free Dividend Discount Model (DDM) Template from Wisesheets

We, at Wisesheets, have 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 along with 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. This allows you to screen for dividend stocks where the dividend yield is higher than the required rate of return.

Altogether, Wisesheets represents you with a powerful tool to give you an edge when looking at many dividend stocks and saves you countless hours of time getting the data and making calculations.

*Note: 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.

Example of how to use The Dividend Discount Model (DDM) to Find Profitable Dividend Stocks

Now that we have seen how to use the dividend discount model, let's look at some examples of how it can help 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 analysis). 

If you calculate the value of dividend stocks this way, it will allow you to buy companies' stocks that are undervalued and fit your criteria. 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 (DDM)

You should include the DDM as an important tool in your investment arsenal 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 their future dividend payments.

Additionally, you can use the dividend discount model to monitor your existing dividend stocks. Keep regularly updating the intrinsic value of your stocks. You can sell those that become overvalued and buy those that 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. You can update the data for each company in the template. This way, you can easily see which stocks are undervalued and worth further research.

Drawbacks of Using The Dividend Discount Model (DDM)

One of the biggest drawbacks of the DDM is that it relies on future dividend payments. This means that the basis of your assumption on which you base the projected dividend payouts might be completely off.

For example, the company could cut its dividend. In this case, the intrinsic value will be significantly lower than before, leaving us with a much-overvalued investment. For example, Judith expected the present value of dividends to be $280, but the dividends get cut and the market price drops below $200.

If Judith purchased the stock hoping it would be worth more in the future, she would be disappointed.

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 or adopts a new technology, expected to be successful, the stock price will likely increase even if the dividend remains the same. Imagine, Stan agreed to sell his stock, for Monroe Travels, one month from now at a price of $45 per share. But the company adopts a new SaaS product that boosts its share price and it overshoots $45 by $100. In this scenario, Stan would incur an opportunity cost for trusting the DDM.

Lastly, it is a simplified way of valuing a company. Hence, use this model in conjunction with other valuation methods as it will not always be accurate.

Takeaway

You can use the dividend discount model as a valuable tool to find attractive dividend stocks. With its easy-to-use template, at Wisesheets, 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. This will help you sort out overvalued and undervalued stocks, and make sound investment decisions.