Dividen Discount Models (DDM)
In this lesson we are going to learn about valuation models with dividends, this will teach you to find the value of a stock according to your desired rate of return. It might seem tedious and a large amount of work, but is essential work to be done if you want to make money in the stock market. Remember you can lose money investing too, therefore we provide some tools to help you prevent loses.
Dividend Discount Models
What is a DDM?
Shares of stock are valued on the basis of the present value of the future dividend streams the stock is projected to produce a.k.a. DDMs, Dividend Valuation Models (DVMs), Discounted Cash Flows Models
Recall: The value of a stock is based on the present value of its future cash flows
Therefore, dividend discount models should be extremely popular, right?
Fact: During the 1990’s, investors who adhered to these types of models were considered old fashioned and outdated. But those investors weathered the 2000-2002 downturn very well. Dividends have become important again
Dividend Discount Model (Purest incarnation)
Value of stock = present value of all expected future dividend payments
Did the formula for the DDM scare you?
This formula has the present value calc built into it
We mortals simply use the Present Value tables
Then, the formula becomes: Value = Dividend1*PVM1 + Dividend2*PVM2 + Dividend3*PVM3 + etc
(PVM1 is the present value multiplier for the rate of growth for one year, PVM2 is the multiplier for two years, etc.)
Let’s do an example:
Using the Present Value Multipliers from the Present Value Table with Three annual dividends of $100 per share and a required rate of return = 15%
Value of stock = ($100*0.870) + ($100*0.756) + ($100*0.658)
= $87.00 + $75.60 + $65.80
(image provided by the Present Value Table)
Note: What is the present value of the future stream of dividends?
At 15%, $100 in 1 year is worth $87, in 2 years $75.60, 3 years $65.80.
The sum of the present values of the future dividend cash flows equals our perceived value of the stock.