How does the Dividend Discount Model value stocks?

Saturday, Aug 04 2012 by
How does the Dividend Discount Model value stocks

"A cow for her milk. A hen for her eggs, And a stock, by heck, For her dividends" (John Burr Willams) 

As valuation techniques go, the dividend discount model ("DDM") is basically a more conservative cousin of discounted cash flow analysis.

It is to be contrasted with asset-based intrinsic valuation techniques like tangible book value or net net working capital, or residual income-based valuation techniques like EVA.

The DDM approach seeks to value a stock by using predicted dividends and discounting them back to their present value. The idea is that, when you buy stock in a publicly listed  firm, the only cash flow you receive directly from this investment are expected dividends. The dividend discount model builds from this to argue that the value of a stock should therefore be the present value of all its expected dividends over time.

This valuation model was popularlised by John Burr Williams who published "The Theory of Investment Value" in 1938. Williams was writing back in the 1930s, when people like him and Ben Graham were trying to establish a science of investing after getting burned by the irrational exuberance of the roaring twenties. Williams decided that focusing on reported earnings was like buying "bees for their buzz" instead of their honey. He argued that the only return you could really believe in was the dividend:

"a stock is worth the present value of all the dividends ever to be paid upon it, no more, no less... Present earnings, outlook, financial condition, and capitalization should bear upon the price of a stock only as they assist buyers and sellers in estimating future dividends".

While many analysts have moved away from the dividend discount model, arguing that its focus on dividends is too narrow, it does have the advantage of simplicity & logic. This model seems a good starting point for valuing stocks, since it sensibly connects dividend payments and growth to the stock price. Dividends after all represent the only cash flow from the firm that is tangible to investors. Ideas like free cash flows to equity (FCFE) are most abstract and prudent investors may legitimately argue that they cannot lay claim to these cash flows. Another key advantage is that there are only a few assumptions involved, whereas deriving forecasted free cashflow involves estimates of capex, depreciation and working capital.

How a DDM Model Works


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