Dividend-paying stocks offer many benefits for investors. They provide a steady stream of income, paying distributions on a regular basis. Dividends also help cut back on investment portfolio volatility when times get tough because they are paid by companies with solid earnings and a good track record.
But sometimes these stocks may leave investors wondering whether to buy, sell, or hold off. One of the ways they can determine the suitability to make a move is by using the dividend discount model (DDM). Although this is one of the most conservative ways to value a dividend-paying stock, it does come with certain disadvantages.
Key Takeaways
- There are a few key downsides to the dividend discount model, including its lack of accuracy.
- A key limiting factor of the DDM is that it can only be used with companies that pay dividends at a rising rate.
- The DDM is also considered too conservative by not taking into account stock buybacks.
What Is a Dividend Discount Model (DDM)?
A dividend discount model is a methodology used to calculate the price of a stock based on future dividend payments discounted to the current date. A DDM tries to calculate a stock's fair value regardless of market conditions. Instead, it considers factors like dividend payouts and potential returns.
The DDM assigns a value to a stock by using a type of discounted cash flow (DCF) analysis to determine the current value of future projected dividends:
- If the value determined is higher than the stock's current share price, then the stock is considered undervalued and worth buying.
- But if the DDM determines that the stock's value is lower than its current trading price, it may be overvalued. As such, the investor may consider passing on it or selling it if they already own it.
While the DDM may help investors evaluate potential dividend income from a stock, it does have several inherent drawbacks.
You can use the DDM to evaluate the potential for newly-traded stocks or those that are traded on the secondary market.
Must Pay Dividends
The first drawback of the DDM is that it cannot be used to evaluate stocks that don't pay dividends, regardless of the capital gains that could be realized from investing in the stock. The DDM is built on the flawed assumption that the only value of a stock is the return on investment (ROI) it provides through dividends.
Beyond that, it only works when the dividends are expected to rise at a constant rate in the future. This makes the DDM useless when it comes to analyzing a number of companies. Only stable, relatively mature companies with a track record of dividend payments can be used with the DDM.
This means that investors who only utilize the DDM would miss out on the likes of high-growth companies, such as Google (GOOG).
Many Assumptions Required
Another shortcoming of the DDM is the fact that the value calculation it uses requires a number of assumptions regarding things like the growth rate, required rate of return, and tax rate. This includes the fact that the DDM model assumes dividends and earnings are correlated.
One example is the fact that dividend yields change substantially over time. If any of the projections or assumptions made in the calculation are even slightly in error, this can result in an analyst determining a value for a stock that is significantly off in terms of being overvalued or undervalued.
There are a number of variations of the DDM that attempt to overcome this problem. However, most of them involve making additional projections and calculations that are also subject to errors that are magnified over time.
According to NYU Stern, "many analysts have turned away from the dividend discount model and viewed it as outmoded."
Ignores Buybacks
Additional criticism of the DDM is that it ignores the effects of stock buybacks. These are effects that can make a vast difference in regard to stock value being returned to shareholders.
Ignoring stock buybacks illustrates the problem with the DDM of being, overall, too conservative in its estimation of stock value. Meanwhile, tax structures in other countries make it more advantageous to do share buybacks versus dividends.
How Does the Dividend Discount Model Work?
The dividend discount model is a valuation method that investors can use to determine whether they should move on dividend-paying stocks. It uses a form of discounted cash flow analysis to figure out the current value of future dividend payments. If a stock's value is determined to be higher than its current price, it's considered undervalued and may be worth buying. The opposite is true in the case of a lower value using DDM.
Are Dividend-Paying Stocks a Good Investment?
Dividend-paying stocks are a good investment if they fit into your investment strategy and goals. Companies that are well-established, have strong fundamentals, and show consistent earnings growth. Dividends can provide you with a steady stream of income and can provide some cushion during times of economic and financial instability.
What Are the Different Types of Dividend Policies?
There are generally three different types of dividend policies. The first is a stable dividend policy, which is the most common. This one pays shareholders a steady stream of income. Dividends are predictable and are paid regardless of whether earnings go up or down. A constant dividend policy is the second type. As the name implies, the dividend remains the same. This means that the policy doesn't guarantee an increase in dividends even if the company does well. The final policy is called the residual dividend policy. Considered a volatile policy, it is used by companies that pay dividends only after capital expenditures and working capital are paid.
The Bottom Line
Many investors are attracted to stocks that pay dividends because they offer a steady stream of income, which can come in handy when times get tough. But there may be times when you want to figure out whether a dividend stock is a good investment, especially if it's newly traded. Using valuation methods like the dividend discount model can help you determine whether the stock is under or overvalued by factoring in future dividend payments at the current rate. But remember, there are downsides to using the DDM, so you may want to consider multiple valuation techniques to make your final decision.
