# Pros and Cons of Dividend Discount Models (DDMs)

Fajasy
Updated: March 17, 2024

### Contents

In this article, I will explain the pros and cons of dividend discount models (DDMs). The DDM is a fundamental valuation method that calculates the intrinsic value of a company based on the dividends it is expected to pay out to shareholders, discounted back to their present value. This approach is particularly favored by investors focusing on income-generating stocks, as it directly assesses the present value of future dividend payments to estimate a company's intrinsic value.

This article will provide an overview of the DDMs, then discuss its key pros and cons. This information is useful for anyone considering using the DDM approach.

## Dividend Discount Models (DDMs) Overview

The dividend discount model (DDM) is a fundamental valuation technique in finance, central to assessing a company's value through its expected dividend payments. Unlike methods that rely on market comparisons or free cash flows, DDMs focus on the dividends a company is expected to pay out, offering a metric for intrinsic value based on future income streams.

DDMs encapsulate the valuation approach through a general formula:

P0 =
t=∞ t=1
E(DPSt)
(1 + re)t

where:

• P0 = stock's fair value value (at time 0)
• E(DPSt) = expected dividends per share (at time t)
• re = discount rate (aka required rate of return)

Thus, the DDM model suggests an asset's value is determined by the present value of its expected future dividends. These dividends are discounted at a rate that reflects the risk associated with the anticipated payments, considering the time value of money.

There are different DDM approaches such as the Gordon Growth Model (GGM), Two-Stage DDM, H-Model, and Three-Stage DDM. Each model adjusts the DDM approach to fit various dividend growth scenarios, from constant growth with the GGM to variable growth rates over different phases with the Two-Stage DDM, H-Model, and Three-Stage DDM.

The general steps for completing any DDM are as follows:

• Step #1: Select the Appropriate DDM: Choose between the GGM, Two-Stage DDM, H-Model, or Three-Stage DDM based on the company's dividend growth characteristics.
• Step #2: Forecast Dividends and Earnings Growth: Estimate the expected growth in dividends and earnings based on historical data, payout policies, and future earnings projections. This may be done across one or multiple phases of dividend growth, depending on the selected model.
• Step #3: Determine the Discount Rate: Calculate the required rate of return to discount future dividends to present value. Typically, the Capital Asset Pricing Model (CAPM), a measure of the cost of equity, is used as the standard discount rate in DDMs. You may need to estimate the discount rate for one or more periods of dividend growth, depending on the model chosen.
• Step #4: Calculate Intrinsic Value: Apply the selected DDM formula to estimate the stock's fair or intrinsic value, incorporating expected dividend payments and the discount rate(s).

In conclusion, DDMs provide a method to value an asset based on the present value of future dividends, factoring in risk and the time value of money. Through various models like the GGM, Two-Stage DDM, H-Model, and Three-Stage DDM, it adapts to different dividend growth scenarios, offering a versatile tool for investors to accurately calculate a stock's intrinsic value.

## Dividend Discount Models (DDMs) Pros

In this section, we'll discuss the pros/advantages of using dividend discount models (DDMs) to value companies.

DDMs stand out for offering clear, objective valuations through dividends, emphasizing conservative estimates ideal for mature, stable businesses. They cater to a wide range of investors, from retail to risk-averse, highlighting their versatility in investment analysis.

### Tangible and Objective Valuation

DDMs provide objective valuations through a focus on dividends as actual cash flows, steering clear of the distortions common to earnings or free cash flow interpretations. They quantify a company's value as the present value of all anticipated future dividends, reducing subjectivity and ensuring consistency in valuation outcomes.

Furthermore, by conceptualizing a business as an entity with an infinite dividend stream, DDMs simplify valuation, making it appealing for its relatively straightforward logic and minimal subjectivity.

### Conservatism and Stability in Valuation

DDMs lead to conservative, stable valuations by focusing on dividends, which are generally more stable than earnings or free cash flow. This stability is particularly valuable in volatile markets and reflects the characteristics of mature, lower-risk businesses that consistently pay dividends.

Companies also aim to maintain steady dividends, avoiding setting high expectations that could negatively impact stock prices if unmet. Any deviations, such as one-time dividends, are usually communicated as well, further enhancing the conservative nature of DDM-based valuations.

DDMs excel in valuing mature businesses, as regular dividend payments indicate a company's stability and long-term viability, implying less future uncertainty. This attribute is particularly appealing to investors seeking reliable income streams rather than speculative growth.

Within DDMs, the lower risk tied to steady dividends also leads to lower discount rates, enhancing the appeal of mature companies known for their consistent dividend policies.

### Suitability for Various Investor Profiles

Suitable for a range of investor profiles, DDMs appeal to retail investors without control over dividend policies and risk-averse individuals seeking dividend predictability and stability. For minority shareholders, often reliant on dividends as their sole reliable return metric, DDMs become invaluable for investment decisions.

Unlike institutional investors who may influence dividend policies through substantial stakes, minority shareholders depend on the assurance of receiving dividends, as evidenced by consistent past payouts. This makes dividends a useful valuation metric for them, highlighting the importance of DDMs in evaluating a corporation's worth from their perspective.

## Dividend Discount Models (DDMs) Cons

In this section, we'll discuss the cons/disadvantages of using dividend discount models (DDMs) to value companies.

DDMs face several cons, including limited applicability to non-dividend-paying firms and a tendency to oversimplify market dynamics. They're sensitive to assumptions, overlook the disconnect between dividends and earnings, and assume unrealistic perpetual growth. Additionally, DDMs may ignore tax efficiencies, shareholder control impacts, and the significance of stock buybacks, highlighting the need for careful application.

### Limited Applicability

A significant drawback of DDMs is their inapplicability to companies that do not distribute dividends, regardless of their profitability or cash flow efficiency. This model overlooks the potential capital gains from non-dividend-paying stocks, resting on the limiting assumption that a stock's value solely comes from dividends. Furthermore, DDMs assume dividends will grow at a constant rate, rendering the method ineffective for evaluating many companies, particularly high-growth or newer firms without a dividend history.

While some investors attempt to predict when a growing company will mature and initiate dividends, such forecasts are inherently speculative, emphasizing the model's confined utility and the challenges in extending its application to future dividend-paying prospects.

### Oversimplification of Reality

DDMs' emphasis on dividends can result in an oversimplification that neglects unpredictable market dynamics and critical company-specific elements such as product innovation and growth potential. This narrow focus may yield inaccurate valuations for companies with variable or inconsistently growing dividends, underlining the model's potential limitation in capturing the full spectrum of an entity's value drivers.

### Sensitivity to Assumptions and Forecasting Challenges

DDMs are highly sensitive to input assumptions such as the cost of equity and growth estimates, where minor changes can significantly alter valuations. Forecasting accurate long-term dividends is challenging, and the model overlooks the potential value from reinvesting earnings, especially in high-growth companies. The model relies on multiple assumptions including dividends, growth rate, and interest rates, many beyond an investor's control, reducing its validity.

This dependency on assumptions can lead to inaccuracies in stock valuation, with any slight error in projections potentially resulting in significant overvaluation or undervaluation. While variations of the DDM try to mitigate these issues, they too require additional projections and calculations prone to magnified errors over time.

### Disconnect Between Dividends and Earnings

The assumption in DDMs that dividends correlate with earnings doesn't always reflect real business behavior, presenting a challenge to the model's accuracy. Companies often maintain consistent dividends in the face of fluctuating earnings to meet shareholder expectations, at times resorting to borrowing.

This practice highlights a complex relationship between earnings and dividends, contradicting the DDM's straightforward correlation and suggesting dividends may not directly indicate value creation.

### Perpetual Dividend Growth Assumption

DDMs operate under the assumption that companies will continue to pay dividends indefinitely, an outlook that overlooks the evolving nature of business landscapes influenced by regulatory changes and competitive pressures. This perpetual dividend payment assumption complicates the valuation of new companies or startups lacking a robust history of dividend distributions.

Moreover, the model risks overvaluing entities if projected dividend growth exceeds the rate of earnings growth, further questioning its accuracy and realism in dynamic business environments.

### Contrarian Nature and Market Valuation Discrepancies

The exclusive emphasis on dividends within DDMs can lead to missed opportunities in identifying undervalued stocks, particularly in bullish markets where the model's focus diverges from broader market trends. Such an approach may overlook potential growth opportunities as stock prices escalate without a corresponding rise in dividends.

Yet, the model is capable of adjusting valuations in scenarios where market upswings are supported by strong economic fundamentals that positively influence dividend payouts, illustrating its nuanced application amidst market valuation discrepancies.

### Tax Efficiency and Shareholder Control Considerations

The DDM's effectiveness is compromised in jurisdictions where dividends are less tax-efficient than capital gains, leading companies to favor share repurchases over distributing dividends. This issue limits the model's utility, especially in areas with tax laws that prefer capital gains or promote share buybacks.

Since dividends might not represent the most tax-efficient method of enhancing shareholder value in these regions, and given that DDMs overlook the tax consequences of different shareholder returns, the model may fail to accurately reflect a company's optimal strategy for shareholder value maximization.

Moreover, the model offers limited insights for significant shareholders capable of influencing dividend policies, rendering it a less pertinent metric for their investment decisions. As a result, investors exclusively relying on the DDM might overlook potential opportunities in regions where dividend distribution is not the favored method of returning value to shareholders, further highlighting the model's constraints in guiding investment choices effectively.

A further critique of DDMs is their oversight of stock buybacks, which can significantly impact shareholder value. This neglect suggests that DDMs may be overly conservative in estimating stock values, not accounting for scenarios where tax structures in some countries favor share buybacks over dividends, thereby potentially skewing the valuation away from actual market conditions where buybacks are a preferred method of returning value to shareholders.

However, the "augmented sustainable dividend growth rate," which builds on the "sustainable dividend growth rate" by including the effects of buybacks, provides a more comprehensive view of how shareholder value is returned. This adjustment to the model recognizes that buybacks, just like dividends, are a way to distribute profits back to investors. By taking into account both dividends and buybacks, it offers a more accurate representation of a company's total shareholder return.

## The Bottom Line

The dividend discount model (DDM) serves as an important valuation tool in finance, offering a direct method to assess a company's intrinsic value through the lens of its future dividend payouts. By discounting these expected dividends back to their present value, the DDM provides investors with a tangible measure of a stock's worth, grounded in the company's capacity to generate cash for its shareholders. This model is particularly advantageous for its straightforward application and focus on dividend payments, making it highly suitable for evaluating companies with a consistent dividend history.

However, the reliance on dividends also introduces limitations. The model's accuracy diminishes for companies that do not pay dividends or have unpredictable dividend policies. Furthermore, the DDM's sensitivity to the discount rate and dividend growth assumptions can lead to significant variances in valuation outcomes.

In essence, while the DDM offers valuable insights into dividend-paying companies' valuation, its effectiveness is contingent on the presence of stable and predictable dividends. It's therefore most suitable for mature, dividend-paying companies within sectors known for regular dividend distributions (e.g., utilities, REITs, etc.). Given its limitations, particularly with non-dividend or irregular dividend-paying companies, it's encouraged to use the DDM in conjunction with other valuation models.

Disclaimer: Because the information presented here is based on my own personal opinion, knowledge, and experience, it should not be considered professional finance, investment, or tax advice. The ideas and strategies that I provide should never be used without first assessing your own personal/financial situation, or without consulting a financial and/or tax professional.