IFB35: A Thorough Breakdown of the Dividend Discount Model

dividend discount model

Welcome to Investing for Beginners podcast this is episode 35. Andrew and I are going to talk about the dividend discount model today.

So we’re going to have a little conversation about a formula, this is something we haven’t done a whole lot of, and without any further ado I’m going to have Andrew go ahead and start us off

What we will learn today:

  • What the dividend discount model is
  • How to find the info to plug into the model
  • Intrinsic value can be found using this formula
  • Works best for dividend-paying companies

Andrew: Yeah, actually I was just going to give a little intro. So Dave and I are working on something on the side. Still too early to say what it is yet.

But I’m excited because we’re working on something big, and it’s something that people have asked for. I think it’s one of the best things you know we’ve ever done even with all these podcast episodes.

So today’s episode is going to be kind of derived from that. Some of the lessons that we’ll learn here really parallel. So I’m excited for this one. I also wrote an email earlier today about dividends, and obviously, I do that a lot.

But in a way it was relating dividends with evaluations, so this is kind of like perfect timing to take what we’ve been working on. Take what Dave’s been working on behind the scenes and give you guys a sneak peek of what’s to come in the future.

Dave wanted to start off with a dividend discount model or models that you have been worth looking at any kind of studying.

Dave: okay, all right awesome so well thank you for that. So dividend discount model, so this is a formula, and we’re going to talk a little bit about that formula.

The dividend discount model is one of the easiest ways to value a company that pays a dividend. And there are many ways to do valuations; there is the Benjamin Graham formula, there’s a discount of cash flows.

Dividend discount model is one of the easiest ones to do. There are only three inputs to it, so it’s super simple. You don’t have to have higher math skills to be able to do this. It’s not extremely complicated; there’s not lots of different variables and formulas and things you have to figure out.

It’s information you can gather pretty easily and put it together, and it can give you kind of a framework and a guideline to look at when you’re trying to value a company. Especially a company that pays dividends, so what this company, what this model will work great for are any company that’s going to pay a dividend.

So whether it’s going to be something like a REIT, which we talked about last week, whether it’s going to be just a normal company like let’s say Microsoft. Or somebody of that ilk you know anybody that pays a dividend this will work for.

What it won’t work for are companies that do not pay a dividend so, for example, Tesla, Facebook, and Netflix. So notice those are really big companies, Google none of these companies pay a dividend so this particular model will not work with them.

So that being said let’s talk a little bit about the formula. So the formula is also known as the Gordon growth formula, there’s a professor back in the 1960s that popularized it.

It was created in the 1930s, but in the 1960s it’s kind of really when it became more popular and was utilized much more. When we buy a stock when an investor when we buy a stock we expect cash flows to come from two areas. One is the current and the future dividend payments. The other one is to increase is an increase in the value of the company as its being held.

So as we don’t hold a company over the course of its lifetime, as it goes up in value that’s going to be one of the other cash flows that we’re going to be. So since the value of the stock is determined by the future value of the dividends. The value of the dividend is its current price to refinish through infinity.

So lets you know the math and everything. I’m going to talk a little bit about as we go forward a little bit farther down here. So let’s talk a little bit about the actual formula itself.

The actual formula is, I’m going to read this out to you guys, and I will put this obviously in the show notes so you’ll be able actually to see this.

The value of the company is equal to the dividend per share, and that’s going to be the future dividend, and we’ll come back to that here in just a moment. And that’s going to be divided by the rate of return on the equity that we expect, and it’s also, and that’s going to be subtracted from the annual growth rate of the dividend forever.

V = DPS / (G – R)

Dividend per share one in the future

G = Cost of equity

R = Minimum rate of acceptable return

So we’re going to talk about each of these components here just a little bit. But I want to talk a little bit about you know the formula and kind of some of the expectations of it.

One of the things about this formula that you need to know about and this is very critical to calculating that and using this formula works awesome for companies that are in the stable growth period of their existence. So if you’re looking for a company that’s exciting, upcoming and has these huge growth rates. It’s not going to work because of the way the value, that the variables are constructed it just is not going to work.

And so you’re what you’re going to look at you’re looking for companies that are going to be more mature, older, stable. Think of dividend fortresses in Andrew terms, or think of dividend aristocrats or dividend kings.

You know somebody a company that’s been around for a long time. Think Coca-Cola, think Microsoft, think Johnson and Johnson, and Colgate. These are all awesome companies that have been around for a long time, been paying a dividend for longer than I’ve been alive.

And you know they’re amazing companies to invest in, and this model will help you get a valuation of whether the company is the intrinsic value of the company is whether it’s overpriced.

Remember what Warren Buffett said, and we talked about this in the past, and I’ll bring this up again. We’re looking at these formulas, and what we’re talking about valuing company, we’re looking for an approximate value. Do not get hung up on if the stock is selling at $22 a share and your intrinsic value comes back at $18 a share. Don’t get hung up on that number so much you use it as a guideline to go okay maybe it’s overpriced and look deeper into the numbers to find out if you think it is overpriced or not.

Don’t get twos you know like asking if it’s too expensive and move on. It always warrants further investigation into looking to whether the company is ready to go or not. And whether you want to buy it or, whether it is overvalued or not.

If you come up with an extremely crazy number, then that obviously is going to bear some other looking into it as well.

When we’re looking at the stable growth rates or the stable growth company, you know the first thing you need to think about when you think about dividends, and this is something to keep in mind with the growth rate as well.

As the discount rate that we’re going to be looking at, the growth rate the way the formula is constructed it looks at the growth rate is something that’s going to go on to infinity.

I’m just going to use a company you know let’s say Coca-Cola. if they’re paying a dividend at a certain rate over a period. This formula is going to act like that dividend is going to be paid at that same rate over the same period forever.

And you and I both know that just isn’t going to happen. You know the companies like Coca-Cola they’re going to continue to raise their dividend for as long as they can. Now whether that goes to infinity, you know who knows that? Maybe but it may not be as well, and so those are things that you have to keep in mind when you’re looking at this, and you know thinking about how you’re going to value that company.

Because one of the things about valuation is your projecting a future value into the company when you invest in it. So if you find a company that is selling at a discount to whatever the stock market is saying it’s valued at. The price is let’s say $40, and your intrinsic value comes up at $20, well you got a 50% margin of safety there.

But that is not necessarily going to last forever so as the value, as the valuation and the price of the company start to merge. Then that margin of safety obviously dissipates, and you know that dividend will also change over time as well. So these things you need to keep in mind when you’re looking at the value of the company.

Because what we’re looking at is one period and it’s not going to continue forever, and so that’s something you kind of need to keep in mind as well. So you know a growth rate that you may come up with maybe you know a much more extended value.

I’m going to talk a little bit now about a gentleman that I have learned most of this from his name is as Aswath Damodaran, and he is a professor at NYU Stern Business School, and if you’ve not checked him out before, you need to. The guy is amazing; he’s an awesome teacher he has so many resources out there to teach you guys about what I’m talking about.

As well as other things and it’s all free. He has some books, it is written with amazing detail. And he’s one of those teachers that’s good explaining things to even dum-dums like me. That’s I don’t have a finance background.

This is not my natural calling, you know I’m a guitar player by nature, and so for me to be able to figure this stuff out I needed a lot of help, and he was able to help me. He has classes you can take an iTunes University you know and again this is stuff is all free.

Let’s talk a little bit about how we calculate some of those variables in the formula. So the dividends per share, so you’re going to be looking at a dividend per share. So let’s think about that, so I’m going to pull up an example here.

Let’s look at Johnson & Johnson for example, so the information that I gathered here from Johnson & Johnson. I looked all this up on a website called gurufocus.com; it’s a freemium site if you will. They have paid subscriptions that you can get that have all kinds of add-on features I don’t use that. But a lot of the information that I can gather is current.

You can gather, and it’s free so the information that we need to gather to kind of start putting together our formula. The first one we’re going to look at is the dividend per share. So the dividend per share that they paid for the last year was $3.36 a share. So that’s the first variable that we need to figure out.

The next variable that we need to figure out if we need to look at the growth rate. The growth rate so here’s the story on the growth rate. There are different ways that you can find on the internet to calculate a growth rate, and they involve different numbers and variables that you’re going to put together.

Here’s the problem with doing that with this formula is if you calculate those growth rates those numbers are going to be higher than the number that you need, and it’s going to lead to a negative number in the numerator.

Which will cause you when you do your valuation to come up with a negative evaluation, and that’s obviously not what we want. So the easiest way to come up with a growth rate is and is to look at the growth rate as a component of the economic growth of the country.

A stable company is not going to by nature is not necessarily going to grow faster than the economy. It could, and a lot of them do but a company that is like say Coca-Cola or Johnson & Johnson. They are not necessarily going to be growing faster than the gross national product of the economy.

Andrew: sorry it’s not so much that you’re like saying that they’re not going to. It’s on the safe side and just say yes less yeah because and make a conservative calculation that way our valuations not way off.

Dave: yep, exactly. That’s a much better way of saying what I was just trying to say. Yeah, that’s exactly right, so you know using more conservative numbers is going to give you a better a better grasp on what’s going on with this. So the way that I did that is I just went online, and I typed in Google nominal growth rate of the economy, and it spits out a number at me.

And so it’s 4.36%, and so that’s the number that I use for the growth. So the next variable that we’re going to calculate, this one is the equity rate that we’re going to generate that we want to see a return on.

This one is a touch more complicated, so what we need to do for this is we are going to be using, so it’s the cost of equity. So what we’re looking for is the risk-free rate, we’re also looking for the beta of the company, we’re also looking for the market risk premium.

Cost of equity = Risk-free rate + ( Beta X market risk premium )

To try to simplify all those terms as best that I can. They aren’t the numbers that you need to calculate. These are all things that you can find through the internet. You can either find him through the Gurufocus, or you can find him on the internet.

The risk-free rate, the simplest way to think of that is the minimum rate you would expect that you would earn on this investment barring any growth at all. So if you invested in this company, you would expect to earn at the very least this particular number at the bare minimum. That’s what you would expect to earn over the long time that you own this company.

Obviously, we’re all expecting to earn more of that but this is kind of in essence a discount rate so this is a rate that you’re going to look at when I invest dollar number one, I expect to earn this much on that dollar over the long period. And this number is something that you can gather from my friend Aswath Damodaran. You can go to you just type in risk-free rate Damodaran and it’ll spit up a chart that he calculates every single year.

There are extremely complicated calculations to go into this and its way above me. But he does it all for us, and he does it by country so you can look at each company in a world and figure out what the risk-free rate is in each particular company.

The United States happens to be 5.69%, so that’s what our risk-free rate is so if we invest dollar number one we expect to earn at least 5.69% on that. So nice top your roll again make you lose your train of thought once again.

Andrew: yep, so is that the same risk-free rate when they talk about like DCF valuation calculations where a lot of times it’s almost like an opportunity cost or you’re cutting like the future value of money is that guess that’s part of a pulse.

Dave: yep that’s part of it.

Andrew: yep can we kind of break that down for people a little bit more than so you’re talking about basically what you expect a company to return so it’s basically and you can apply this to stocks more so than investments. But I’m sorry investments, and you know more so stocks it’s what return you expect to get from your money so you can compare what’s this particular stock too if I invest it in either government bonds or something a little bit riskier

Dave: yeah exactly that’s exactly right that means that breaks it down as simply as you can. I mean if you know it compares if you buy Company A versus buying a Treasury bond it it basically breaks down that you should you know expect to earn 5.69% from stock A. Whereas you know you will not earn that from a Treasury bond so and please look at Treasury bonds just for like the absolute newbie.

Andrew: we look at Treasury bonds it’s kind of like the most risk-free that you can get because the only way those would never go worthless is if the government failed, so that’s why we use that one.

Dave: yeah, exactly right and you know speaking of Treasury bonds that is one of the variables that we would plug into the cost of equity formula that we’re going to use. And since we’re talking about that will kind of segue into that.

The Treasury bond in there’s several routes you can go professor Damodaran goes with a ten-year rate. I know where Buffett goes with a thirty-year rate, it depends on which route you want to go.

For simplicity’s sake to follow along with what I’ve learned I did the ten years. So the ten year Treasury bond and again this is something that you can find on the net.

You just type in 10-year Treasury bond rate, and it’ll spit up a number for you, and it varies every day. Treasury bonds as Andrew was saying are something that’s guaranteed by the United States government and it is considered you know a bare minimum of whatever you should make if you were going to invest. So if you invest in the company an if you don’t make at least 2.33%, you are you know the throwing your money away and because you could have easily just thrown that in the ten year Treasury bond and earn that rate and not done a single thing.

I had to worry about any volatility and the sort of risk because this is that’s kind of where that comes in. So the market risk premium that we’re discussing now that is equal to a ten year Treasury bond rate which is going to be 2.33%, does that is that pretty clear do you think?

Andrew: Yeah, perfect.

Dave: okay, awesome, so the third variable that’s going to be in our cost of equity formula is going to be beta. And beta is something they enter, and I have not talked a lot about I’m going, being honest with you I’m not super keen on it, but it works well for this.

And really what beta is all we need to talk about beta sometime soon okay. Beta you know I’ll be perfectly honest and say that I have not dealt deeply into beta. What I do know about the beta is it’s a measure of a volatility of a company comparing it to the stock market.

So the higher the number goes above a one though in theory the more volatile it’ll be. So that’s that’s what I know about it. Andrew if you know more about it.

dividend discount model

Andrew: that’s yeah let’s look back with that for now because I could go a whole episode about that.

Dave: okay, yeah all right. so if we figure out what the if we plug all those numbers into the cost of equity for a company. So let’s take let’s take Johnson & Johnson for example so if we plug all those numbers in we’re going to get a cost of equity of 7.15 percent.

How I’m getting that is I’m taking 5.69 percent, I’m adding that to 0.63 which is the beta is according to gurufocus, and I’m multiplying the 0.63 by 2.33 percent. Doing all those calculations, I come up with a cost of equity of 7.15%.

Then what we would do simply to figure out the cost of everything, so the first thing we’re going to do before we go any farther with that.

So we talked a few moments ago about the dividend per share, so the dividend per share for Johnson & Johnson is $3.36 a share. To figure out what we need to figure out what the future of that dividend would be for next year. To do that we would take the growth rate which we already talked about which was going to be the growth rate of the gross national product of the United States.

And so that rate as a conservative rate was 4.33 percent so we would take that 4.33 percent times the $3.36 and we would come up with a future value of the dividend per share. We’re going to come up with $3.70, so $3.70 is going to be our future dividend for next year.

So 2018 you know based on that growth rate that’s what we should expect as a dividend. So to figure out the value of the company what we think it should be we would simply take 3.70 and divide that by 7.15 percent minus 4.33 percent.

Then we would do the calculation, and we would come up with a number of it comes up to,

Andrew: yeah so one hundred nineteen dollars and sixty-nine cents are that what you said.

Dave: yeah okay, so it comes out to $119 and 69 cents. So based on the current stock price of Johnson & Johnson, they’re at like $132. 89 right now.

so according to our calculations, the company is overpriced, so that would mean that that would bear some looking into two if we think that this is going to be something that we’re going to invest in.

You can do this on any value you know any dividend-paying company. It’s I hope you see that it’s not that complicated, there are a few variables that you need to think about.

You need to kind of work through a little bit, but if you use the conservative growth rate. And you look at the cost of equity and those two things it’s going to be pretty simple.

Andrew: Okay so now you broke down the formula nicely. so well there are some things that we can kind of take away from this. So again the obviously the value we are calculating you want it to be as high as possible because that’s going to show a stock that’s valued very highly.

Then you compare it to what the current price of the stock is in the market, and that’s going to give you a good comparison. Where if you see one that’s much higher than the other then that kind of signals a margin of safety.

On the flip side it’s the other way around, so obviously, the numerator is dividend per share so that one factor is going to be huge in determining this whole thing. So I think something that’s something that you won’t you want to consider is that this is very heavily dividend focused.

There’s not a lot of consideration into how much the company’s grown so far; there are some of the earnings growth of the past couple years. I don’t believe that’s looked at in this formula there is an element of the price, so you’re getting a valuation in the sense that once you compare this value to the real stock price and that’s giving you kind of like a valuation type thing.

So I think these are all questions you want to ask not just for the dividend discount model. But anytime you’re looking at a valuation model is okay well there’s some takeaways and whether things that the formula is calculating. What is it not calculating so you can see some strengths and weaknesses?

Obviously, not one valuation model is perfect our friend Jae Jun likes to calculate was like three or four different models in his spreadsheet. Everybody has their unique take, so this is obviously a fantastic tool.

The dividend per share that’s going to be huge and then the risk-free rate and the growth rate. Those are big factors as well, so what I see from that is because of that R minus G the risk-free rate minus the expected growth because that’s in the denominator.

We want that to be as small as possible, so you want the expected growth to be much higher so from what I’m getting at from what you’ve talked about today in this episode.

You want the GDP of the US to be as high as possible, which will drive this denominator as low as possible. And that’s going to have a big factor in this model as well.

Dave: yes, you’re correct on that. Yep, so as the economy grows that will help with evaluations of the company, so it’s a nice it’s a nice way to give you a valuation no matter what the markets are doing, and it adjusts more to the market than some of the other valuation models might.

Andrew: because you’re going to have obviously stock prices are going to rise and fall you know as you get bear and bull markets through economies cycles. Recessions, all those types of things here you’re going to see obviously that’s going to be fluctuating. But you’ll also see the formula adjust as the expected GDP is adjusting as well.

So I think it’s very important that you are getting the right values for that GDP so you said was a gurufocus.com.

Andrew: yeah which they’ve featured a couple of cool guys on there before. Mm-Hmm speaking from experience that’s it’s a good website

Dave: yeah it is it is a cool website, I like it. I use it a lot, it’s very user-friendly, and it’s got so much information. It’s just obscene I mean fines has a lot of information as well, and we’ve talked many times about how much we like that, it’s a great stock screener but yeah guru focus.

You know the thing I like about it is they have all the different formulas, and they have all the different ratios, and they have you can look at the spreadsheets and the income statements and the cash flow statements, and you can see just everything kind of right there at your fingertips.

If you know the other cool thing about it too is let’s say you’re looking at return on equity in a company you’re like well where do they get those numbers from. You can just click on the roe, and it’ll take you to their formula.

This is how they got it, and this is where the numbers come from, and then you can take that and look at the actual 10k and go oh okay that’s where that number comes oh that’s where that number comes from.

And it just kind of helps you put all the pieces together, so it’s a great learning tool they’ve published.

Andrew: you too right yes each other they’re covering all the cool guys. Good yeah all the cool guys, just as far as like the whole dividend thing goes I think it’s important to understand that there’s a lot of opportunity in pursuing dividend companies.

I’ve said this before on the podcast, but there are two different camps. There’s like the dividend camp and then like the value investor camp. A lot of retirees tend to gravitate towards the dividend camp. And a lot of younger guys tend to gravitate towards value.

I mean value isn’t much so dividing, and demographics like dividends are, but there’s just a lot of tuning because there are not many people who are combining those two things. So I talked about this in my email this morning how Benjamin Graham, obviously we’ve talked about him over and over again. He wrote the Intelligent Investor; he mentored Warren Buffett.

When he first came out with his first book Security Analysis, that’s considered one of them I mean it is basically considered a textbook of volume busting. That’s something like seminary a hundred pages and staring at it right now oh my desk here, and it’s thicker than the Bible.

There’s just a lot in there, and he talked about using dividends as part of evaluation as well. So I know he didn’t talk about it much in the Intelligent Investor, and I wonder if he kind of moved away from that. But it’s definitely in there, and he and he talk about using dividends as well as using them multiple to earnings.

And creating what you perceive a company’s value to be based on that. And so I again I wrote this in the email he had a specific formula that can go into the nitty-gritty there but basically what it came down to was a company who was paying 100 percent of their earnings versus a company that didn’t pay a dividend.

The difference there was like a Forex where the company that paid that much in dividends was worth four times more. Well I think is important also to think about when you talk about the dividend discount model or this dividend capitalization rate that Graham taught and Security Analysis.

Is that why this valuation works and the mindset you have to have along with it is you’re more so calculating what kind of return you’re going to get as an investor. More so than you are calculating the intrinsic value if that makes sense. So you’re factoring like personal gain on the investment and including that rather than just looking at like just the business itself.

so it’s adding this secondary component to looking at instead of I don’t know I hope that makes sense because it’s a big takeaway but you kind of have to separate it into that kind of I don’t know like it’s just like I’m just imagining like separation where you have to pull that apart and really see it that you’re not just looking solely at the company solely at the value of the company and solely as that value is growing. But you’re also looking at how is this valuable to me in the sense of I’m going to buy this as an investment.

This is the cash flow it’s going to give me as a dividend investor, and this is why it’s a good investment for me compared to my opportunity cost compared to what else is out there in the investment world. And just in general how great of an investment it is and obviously valuation and price all those types of things all get wrapped up in there. But I think even if you’re not primarily focused on dividends I think it’s important to understand these concepts and it’s always good to have different valuation models in your tool belt.

Kind of in your inventory so to say it’s just smart and you know even if it doesn’t speak to you I think it’s under it’s important to understand and it can be useful at different times so try to understand them and use them as you see fit.

Dave: I agree then that you know that’s a big reason why I started looking into this particular model, as well as the discounted cash flows as well as the Benjamin Graham formula. Because I wanted to have different ways of looking at how these things all work in the Benjamin Graham formula. As well as the discounted cash flows don’t take dividends into account. And so you know as I’ve you know read from you and Ben Reynolds, you know dividends have a huge impact on our investment performance in our returns and you know, as you’ve pointed out many times.

When you have a return that you’re earning even if the company is not doing well you’re still getting that dividend, and that’s still a percentage of return. You’re getting so if the company is paying 3.2 percent and a dividend and the company is not earning you know growing that there.

You’re still getting 3.2 percent on that dividend so I mean that’s you know that it’s nothing to sneeze at. So you know that’s to me why it was important for me to look at this you know a while back and to continue to sharpen what I’m trying to do with it.

Andrew: yeah I loved it, was such a great breakdown and obviously when you start to talk about things I’ve talked about its just music to my ears. I mean not even just the guarantee in return you’re getting but if you’re reinvesting that oh man like you’re talking about growing your ownership and multiplying what kind of returns you’ll get in the future.

As long as these companies recover and you know many of them do and you’ll have growth you know times and years where maybe earnings don’t grow, but if you’re continuing to accumulate shares then once earnings to grow again, once the economy gets booming again. Now you’re not only is your stock price shooting up, but the total amount that you’ve gained is completely exploding and expanding like a helium and the balloon.

Because you’re holding and reinvesting these dividends is just so much possibility there so definitely use dividends. Get dividends collect; dividends hug, dividends cuddle with dividends and reinvested ins all day long.

Dave: yep, I agree preach on brother preach on. Maybe hopefully at least at least on your computer maybe yeah I’m not singing solo happen to stick to the guitar buddy yep pretty much yeah I always sing when they put a mic in front of me, and they pay me, and even then I turn it down

Andrew: maybe we’ll spare the listeners for tonight then.

Dave: yeah that would probably be best for everybody’s benefit.

All right folks, well that’s going to wrap us up for tonight. I hope you enjoyed our discussion on the dividend discount model. I hope you find it as easy as I was hopefully able to explain it to you.

If you have any questions on this at all, please don’t hesitate to reach out to Andrew and I would be happy to answer your questions and don’t forget to go out there and invest with a margin of safety, find some good intrinsic value and you guys have a great week, and we’ll talk to you next week.

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