A dividend discount model is a financial model that values shares at the discounted value of future dividend payments. A share is worth the present value of all future dividends. As it values shares on the actual cash flows received by investors, it is theoretically the most correct valuation model.
Dividend discount valuation
A dividend discount model would typically be a discounted cash flow (DCF) using dividend forecasts over several stages.
- If there are any dividends that have been announced but for which the share has not yet gone ex-dividend, these are known amounts in the near future and do not require forecasts.
- There are likely to be forecasts based on detailed financial models for the near future (the next two to five years)
- Beyond that, forecasts based on less detailed models (for example, assuming a gradual reduction in profit growth and a fixed payout ratio) can be used
- Assuming a fixed growth rate (typically equal to the long term growth rate of the economy) beyond some point (say after five or ten years) allows a terminal value to be calculated at that point
As the cash flows being discounted are returns to shareholders, the appropriate discount rate would be the estimated required return on equity. This would usualyl be estiamted against market rates usinga model such as CAPM.
Problems with dividend discounting
Problems with dividend discount models include the difficult of forecasting dividends and potential benefits of owning a share other than dividends.
One problem with dividend discount models is that long term forecasting is difficult, and the valuation is very sensitive to the inputs used: the discount rate and any growth rates in particular.
This much is true for any DCF, but a dividend discount model adds an extra layer of difficulty to the forecasts by requiring forecasts of dividends, which means anticipating the dividend policy a company will adopt. As with other DCF models, the discount rate is most likely to be calculated using CAPM.
It can be argued that changes to the dividend policy do not matter, as the money belongs to shareholders however it is used. However, in this case, one might as well use a free cash flow discount valuation.
Dividend discounts also omit cash flows other than discounts, for example:
- the potential benefits from a takeover bid which gives shareholders a one-off cash flow which usually comfortably exceeds the value of the dividend stream that would be expected without the takeover, and,
- other benefits that may be gained through having a say in the running of a company.
This is well illustrated by the price differences between shares of different classes entitled to the same dividends but wth different voting rights. This is discussed in more detail with regard to the reasons non-voting shares trade at a discount.