﻿Today, I’m going to explain how to value dividend stocks, using the dividend
discount model. Let’s get right to it! My name is Zach and you should leave a like
and subscribe to the channel if you enjoy the video.
So what is the dividend discount model? It’s a method of estimating intrinsic value based
on the theory that a stock is worth the sum of all of its future dividend payments, discounted
back to their present value. This is conceptually very similar to my last video, where I went over
discounted cash flow. The main difference is that instead of using free cash flow, we focus on the
dividend. Obviously, this method only applies to stocks that pay a dividend. It should be
used on mature companies, who have a history of consistently increasing their dividend payouts.
Here you can see the general formula for DDM. The present value is equal to the summation of future
dividends, each discounted by the proper discount rate. You have the dividends from the first year,
added with the chunk from the second year, all the way up to the nth year.
The importance of discounting the future dividends is because of the time value of
money. One dollar in the future is worth less than one dollar today due to the opportunity
cost of investing it or earning interest. I built out this calculator for the dividend
discount model. The main inputs are the annual dividend per share, the reasonable annual
growth rate of that dividend, the total number of years simulated in the model,
and the discount rate. There are different approaches to the discount rate. Many online
sources recommend using the cost of capital. This uses the capital asset pricing model,
which can be se here. You can look that up if you want, but I’m not going go over it in this video.
Personally, I think this method has problems. It uses variables like stock price volatility, which
is not the same thing as business value risk. I like Buffett, Munger, and Graham’s idea of
basing discount rate off the available “risk-free rate” and the opportunity cost of investing.
Basically, what you could earn annually elsewhere, or what you would want to earn based on the
environment. Changes to the risk free rate will impact this number. I discussed this idea in depth
in my previous 2 videos on valuing stocks. Alright, so now that you understand the logic
behind the Dividend Discount method, let’s get back to the calculator. To perform the
calculation, I used the summation shown here. This is logically equivalent to the other formula,
but allows for inputs to the growth rate and actual summation calculation. The exponential
is needed for the growth rate and discount rate calculation because they both compound over time.
Let’s do an example. In my previous videos I did Walgreens Boots Alliance so I’ll use that again.
The current stock price $48.34. The current dividend is $1.91. For the dividend growth rate,
we’ll lean on the conservative side and put 5%. Over the last 10 year the dividend CAGR was 9.63%
and over the last 5 years it was 5.26%. We’ll keep the total number of years to simulate at 100,
since I’ve seen that as the default in other calculators. For a business,
the number of years is theoretically forever, or until it no longer operates. It does become harder
to predict the longer you go out though. Then for the discount rate we’ll put 8%. This is more of a
guess, than an exact science. I explained how to determine discount rate in much more detail during
my last video on discounted cash flow. Let’s hit calculate and it shows a present value of $62.85,
which is 23.09% below the current price. Changes to the growth rate and discount rate
will impact the calculation dramatically. This is why it’s important to invest with a
strong margin of safety in case of potential errors. The inputs need to be realistic and
may prove to be inaccurate. In those cases, garbage into the model, equals garbage out.
If you’re using the dividend discount model it’s important to make sure the company will actually
be able to support this dividend overtime. So look at their payout ratio, consistency
of payments, and future growth ability. Now that we understand the dividend discount
model, let’s share some critcism. The model’s focus on dividends makes it miss out on the full
picture of the business. Dividends matter, but are just a part of the overall equation. I think free
cash flow is a much more accurate measure of a companies value. This is the money, from which
they have the ability to pay dividends, buyback shares, invest, and payback creditors. Luckily,
I made a detailed explanation of how to do discounted cash flow, which is linked here.
The dividend discount model results in a much more conservative estimate than discounted cash flow.
For example, if a company consistently pays out 50% of their free cash flow as dividends,
then the discounted dividends would be worth 50% of the discounted cash flow.
Also, in the dividend discount model, a company that does not pay dividends is worth nothing.
We know that’s not accurate. It’s all about cash generation and capacity to pay dividends.
As an investor, I still like dividends because they provide cash flow to reinvest.
Thank you for watching Dividend Data. I’d greatly appreciate it if you leave a like and subscribe
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The link is in the description. Please leave a comment below and thank you for watching!