Hi I'm Jimmy. This is the second video in our valuation series in this video we're gonna
look at how to use the dividend discount formula to calculate the fair value of a stock. You
might also hear called a DDM formula in our first video in the valuation series. We looked
at using the discounted cash flow to try to come up with the fair value of a stock. This
technique is very similar to that technique except this one is actually a bit simpler
because there are less assumptions that need to be made. OK so let's get started. So in
its simplest form this is what the most basic version of the DDM formula looks like. And
the goal of this is to ultimately try to determine the present value of future dividends. So
this formula is actually a one period DDM formula. Ultimately that means that what is
the holding period in this example is just one year. What is that worth today. OK. So
what does this formula tell us. So D1 is the dividend. Next year's dividend P1 is the price
we expect to sell the stock at next year and then we divide that by one plus R, R as our
required rate of return. So this version of the formula actually doesn't do a whole lot
for us when it comes to valuing a stock but it can do a good job of illustrating how the
dividend discount formula works. And the theory behind it. So looking at this formula let's
pretend that we're going to value a company. Now I'm going to use real examples in a moment.
I just want to take just take a second to go through a hypothetical example to illustrate
how it works. OK so this hypothetical company we believe that we're going to get to sell
their stock back to the market in one year for a 100 dollars per share. We also expect
to receive five dollars in dividends in one time period. So that will give us the total
amount coming in of one hundred and five dollars. Okay now a required rate of return. Let's
pretend that our required rate of return is 10 percent. So at the bottom we're gonna have
one point one that represents above 10 percent if it was 5 percent to be one point zero five.
Okay some basic math and we can calculate that the fair value of this stock is ninety
five dollars and forty five cents. And if we think about it this actually makes a decent
amount of sense because we need to return 10 percent that's what the required rate of
return is telling us. Well if this stock let's pretend it wasn't paying our five dollars
in dividends it was paying off ten dollars. Well then we could we could buy this stock
for one hundred dollars assuming we were gonna sell it for a hundred dollars in a year. And
if it paid a 10 dollar dividend that would be our 10 percent required rate of return.
Now obviously it doesn't often work out like this. How would we know what we're going about
to sell the stock for an a year. Now if this is the bond market. Well there's a fortune
to be made in the bond market because formulas like this are far more efficient over there
where things are a bit more defined than they are on the stock market. But either way sticking
with stocks. Now what if we wanted to hold this stock for more than one year. Well if
we're going to do it for let's say three years now the formula is pretty simple. Dividend
at year 1 divided by one plus r to the power of one you're two divided by one plus r to
the power of two. Same thing for year three and then in year three and this example we're
going to assume a price that were once again selling the stock at, so we could use this
exact formula for home many time periods. We want to use if we believed we could reasonably
forecast however many time periods this could work. But what if we wanted to hold it forever.
What if we weren't sure what the selling price of the stock would be at the end. Well this
is another version of that formula same exact formula just a different version of it. And
this one's much more usable. The concept is exactly the same as the other versions except
this one slightly better for stocks. So now we're gonna use a real company two of them
actually. So we could try to illustrate two different versions of the DDM formula to try
to come up with the fair value of a stock. OK. So by the way with this formula. Well
this is excellent for trying to value a dividend ETF. If you've ever been curious how to value
an ETF. This works very well for dividend ETFs. So if you're curious this is also called
The Gordon Growth model. So what are we looking at here. So D0 is the dividends that have
been paid out today. So let's say the dividends that are being paid out over the past year.
So this information we're gonna get from Yahoo Finance once again and we're going to the
example this first example we're going to use Johnson and Johnson. They're a mature
company and they've been consistently increasing their dividends for a long time and that's
sort of the target profile we're after with this type of valuation technique. So if we
go to the historical data tab we can go to this area where it says show historical prices
and switch that to dividends only hit apply and boom we have the past year's dividends.
And just like that we add these up and we have how much has been paid out in the past
year by Johnson and Johnson add these up we get three dollars and sixty five cents. So
three dollars and sixty five cents is D0. So now need g g is the expected growth rate
of the dividends for the long run. So we pulled down their numbers again from Yahoo Finance
and then we switch it from the past year to let's say the past five years it goes as far
back as you want. Well then we add these up and we calculated what the growth rate is
year over year. Well I calculated some growth rates and it turns out that the one year growth
rate is about six point seven percent. The three year growth rate was about six point
two percent in the five year growth rate was about six point four percent. So let's take
an even number we'll call it a six percent growth rate. Now I'm okay with this because
I checked on the financials and I calculated Johnson and Johnson's payout ratio and the
payer ratio they're paying out about 60 percent of the profits. So in theory they'd have a
little bit of wiggle room if their profits were to fall if they would go a bit high.
I think that they can consistently continue to increase their dividends at least in the
foreseeable future. Now we take this three point six five and we multiply it by one point
zero six to represent the 6 percent growth rate and that gives us three dollars and eighty
seven cents. So that was the purpose of this entire pot top part of the formula to try
to come up with next year's dividend. That's what D1 is we saw that in the previous formula
we looked. Well if you happen to know analyst reports if you happen to have an idea of what
difference is supposed to be next year you could use that but either way that's the goal
here. Come up with next year's dividends. Now we're going to apply that same growth
rate to the bottom part of the formula. So just plop in that zero point zero six to the
bottom. So just are on the same page. The growth in the top growth in the bottom same
number. Now we need are so are is required rate of return. Now I wonder how to calculate
a required rate of return using the weighted average cost capital and the capital as a
press model in our discounted cash flow video. But this process actually takes a few minutes.
So if you're not sure how to do that or if that's something you'd be interested in learning
I put a link in the description below to that video and I've said it to when you click on
the link it brings should bring you right to the exact moment where we're talking about
how to calculate r but in the meantime here's some basic data that I'd use for our calculation.
And I actually took a more conservative number ultimately rounding up our weighted average
cost of capital to about 8 percent. So using a weighted average cost of capital of 8 percent
a growth rate of 6 percent that would imply using the DDM formula that the fair value
of Johnson and Johnson stock would be about one hundred ninety three dollars per share
right now. Johnson Johnson is trading at about a hundred and forty dollars a share. So according
to our DDM formula it would seem that Johnson and Johnson It looks like a pretty good deal.
Okay. Great. But what about a company like Lowe's Lowe's also pays a great dividend but
their dividend rate increasing on an annual basis has been in the high teen range call
it 17 18 19 percent. So no company can continuously grow dividends by 18 percent a year indefinitely.
Okay. So clean this up a bit. So now we have the exact same formula but now you may notice
that we add the L next to both growth numbers. So L stands for the long term growth rate.
And then we add this this is a transition period. So let's walk through this new formal
real quick. So D 0 is once again the dividend for the current year for low as that was a
dollar ninety two then H stands for half life. So ultimately what we're trying to do is we're
trying to determine how long it's going to take for Lowe's to decrease from their current
rate of let's say 18 percent. How long will it take for them to go to a long term growth
rate of let's say 6 percent we use the same one that we use over for Johnson and Johnson.
So let's imagine that Lowe's is going to gradually decrease the rate that they increase their
dividends from 18 percent down to 6 percent and let's pretend they're going to do that
over the next 14 years. So the H represents half of that. So then we plug in 7 which is
half of 14. So once again the theory here is that Lowe's is going to gradually decrease
their dividend growth rate every year until it hits 6 percent in 14 years. That's what
these assumptions are telling us so that we plug in the rest of the formula that is the
short term growth minus the long term growth and then we divide that by R minus long term
growth rate. Now notice that the r here the required rate return for Lowe's is different
than what we used for Johnson and Johnson and the reason for that is that Lowe's has
a higher beta so that would impact the required rate of return we would expect in theory beta's
supposed to represent risk. So beta for Lowe's is higher than it is for Johnson and Johnson.
And if you're going to take more risk with a stock you would expect a higher required
rate of return. That's why that number is higher. So we can get all the numbers for
the top section from the bottom section, we can drag those number up to the top and then
we calculate that, well that adds about 68 dollars per share in value to our calculation
just so we know that calculation is the exact calculation we used for Johnson and Johnson
so if we had applied that exact formula to this we would have gotten a 68 dollar value
per share. but then we add the transition period formula, that gives us about 58 dollars
per share in fair value giving us a total fair value of lowe's stock of about 122 dollars
per share. now if we compare that to their current price of about 100 dollars per share
well according to our H model DDM formula, this is called the H model, well it seems
that lowes' stock seems like it has a bit of upside so that just about summarizes the
DDM formula and it has a few more wrinkles that we could look at if we wanted to. But
I just want to point out. Be aware of the amount of assumptions that are going into
this. so you wouldn't want to really just guess like we did here just as an example.
It really want to have some logic behind why you were picking the numbers you were picking
and if you're interested in seeing any other variations of the dividend discount model
please let me know. I'd be happy to put those in the comments below I'd be happy to do other
versions of this. Besides that I intend on further developing the videos in the valuation
series. So if there are any valuation techniques that you're most curious about please let
me know in the comments below. And if you haven't done so yet hit the subscribe button.
Thank you so much for sticking with me all the way to the end of the video. I'll see
you in the next video. Thanks.