Dividend discount models are one of the easiest ways to value a company that pays a dividend. Typically the only cash you receive from stock is its dividend. In this article, we're going to talk about the dividend discount model and how could be used to value a firm and find a firm share price.
So when we think about a dividend discount model it's a good idea to kind of think conceptually that we've got a firm and what we can do is view this firm as a stream of dividend payments into the future into infinity. Well, we can also say it as a perpetuity, we're just thinking forever this firm is just going to spit out dividends. It could be ten dollars each year or maybe this number is growing, maybe it's ten dollars and then in the next year twelve dollars and then fourteen.
Whatever the case we are somehow valuing this stream of dividends going forward and saying, how can we discount those dividends and just basically value the firm based on these dividends that we're expecting to occur.
Gordon growth model
We've got one way that's the most popular way of valuing the firm with a dividend discount model is called the Gordon growth model. This Gordon growth model it's actually a very simple equation we're just going to have the firm's share price that's going to be equal to the dividends in the next period (dividend per share on an annual basis) and then that's going to be divided by the cost of equity after subtracting the growth rate that we're expecting for the dividends.
Let me just talk about these in a little bit more detail, we've got P that's the share price, ultimately that's what we're trying to solve for and how much is this firm worth on a per-share basis. Then when we've got the d1 we're looking at the next year's dividends annual per share. Then the G is just that growth rate. Then of course we've got r which is our cost to equity, we can also solve this actually if it's (r) not given in your problem. You can just go ahead and solve for that using the capital asset pricing model.
So let's go ahead and let's work through an example here. Let's say that that you have a firm and you're trying to come up with a valuation and in this example. You've got next year's dividends per share of two dollars a share. Now the cost of equity let's assume that that's 12% and then what do we have for the growth rate? Well, now we've got to make an assumption here, so let's just assume that the growth rate of these dividends in perpetuity is going to be 3%.
It's now the rest is pretty simple because we just use our equation and we plug in these numbers that we were given in our example. We can go ahead and calculate for a share price. Now we've got the $2 per share and then in the denominator, we're going to have the 0.12 that's our cost of equity and then we're going to subtract out that growth rate which is 0.03 this is all in the denominator. Ultimately we're going to have 2 divided by 0.09 which is going to give us a share price in a sounded of $22.22 a share.
So this is the share price of this firm. We might say okay well what are some issues with it, if it's this easy to value a firm then why are people paying analysts a great deal of money to go ahead and value a firm if you have to do is make some estimates and calculate this simple equation?
Why we shouldn't use Dividend discount models?
Well, there are a few caveats here that are very important. First of all, when you're calculating this growth rate of dividends you're assuming this is a constant growth rate, right you're assuming every year forever that the firm's dividends will grow at 3% that's a pretty big assumption. I mean in reality at some point the dividends might not grow they might not grow at all the firm might just say "well we're not going to increase our dividends anymore" and the shares on steaming doesn't change there's a lot of things that could happen and we don't have to get into all of them but the idea is that this is very unlikely to actually take place, maybe even a hundred years from now this firm might not even be existing but we're assuming this constant perpetual growth rate which might not is very likely not to be very realistic.
It's kind of a rough estimate and kind of another problem is what if the firm is not paying dividends? What if we have a firm like Twitter or some kind of firm that maybe it's an in IPO? Maybe we're trying to value a firm that is just about to be offered to have its shares offer to the public for the first time, the firm has never paid dividends. Then this growth rate becomes even more problematic of trying to estimate the dividends. This is something a lot easier for a mature firm that's paying dividends and isn't really in that growth stage anymore, of course, you could use some kind of proxy for dividends you could say like "well, instead of growth rate we'll use earnings per share as a proxy" but earnings per share aren't the same as dividends, so we're getting even further from what we're trying to do.
Ultimately it's just important to bear in mind that is easy as this calculation just takes a few minutes to do this built on a lot of assumptions and so you should know just bear those assumptions in mind when you're thinking that you have a valuation based on the dividend discount model.
