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To understand the dividend discount model, we need to start from the basics. The simplest way to understand the dividend discount model and its application is to first start with a single period and then later extend it on to more complex cases. Hence, the term single period dividend discount model.
The objective of application of this model is to derive what the fair market price of the stock should be if we know certain other information about that stock. The other information is the expected future price, expected dividend payout in that single period and the investors required rate of return.
Let’s understand the application of a single period dividend discount model with the help of an example:
An investor is wondering what the correct price of a share should be? He knows that his required rate of return is 9%. He also knows that the share will give a $5 dividend in the current period and the expected market value at the end of the period is $200. What would the fair price for such a stock be?
Calculation:
We know that the value of the stock is equal to the present value of all the future cash flows that can be derived from it. In this case we are getting cash flows in two different forms. One form is dividends and the other form is the final sale proceeds.
Let’s call the dividends D1 and the final sale proceeds P1. Thus the total cash flow that we will obtain at the end of the period is D1+P1. Now the next task is to calculate the present value of these cash flows i.e. discount them at the expected rate of return for the investor.
Hence, the formula pertaining to single period dividend discount model is:
Present Market Price = (D1+P1)/(1+r)
Therefore, in our case, it equals:
($5+$200)/1.09 = $188.07
Thus, the fair market value of this stock should ideally be $188.07
In case the investor is fairly confident about all of his/her assumptions then the stock will provide them with a value equal to $188.07 in present value terms.
The single period dividend model can tell you whether a price is overvalued or undervalued if two variables which will become known only in the future i.e. the future price and the future dividend are accurately predicted today!
Also, while theoretically investors are supposed to know their required rate of return, not many investors actually do! So the third variable being used in the formula is also slightly difficult to predict.
Needless to say, this is not a very good idea. Guessing an accurate dividend itself may be difficult. However, guessing an accurate future price is almost impossible! Therefore, it may seem like this model is not very useful and it really isn’t if you consider it on its own.
However, this model forms the building block for later models some of which are based on more realistic assumptions and are therefore much more applicable and helpful.
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