Well, it's a technique used to value companies. Or at least it was…in the stone age. The 50s, maybe.
It basically says that a company’s value is fully contained in the cash dividends it distributes back to investors.
This model is only useful for its historical relevance. Back in the old-timey caveman days, when there was essentially no research of real merit being done on the performance of investments of whatever flavor, the dividend discount model was the best thing investors had to value and investment in a company.
And remember: in those days, companies paid real dividends that were a meaningful percentage of the total value of the company.
Example:
A company pays a dollar a share this year in dividends. Historically, it has raised dividends at 3% a year. The dividend discount model discounts back to present value. A few odd things are worth noting in this horse-and-buggy-era formula. The Dividend Discount Model ignores the terminal, or end value, of the company. Like...say 20 years from now, the company is sold. The dividends are all that are really focused on. Seem strange? Well, maybe...but let’s say the discount rate is 10%, and the risk-free rate is 4%, for a total of 14% a year discounted back to the present. Doing the math, just looking at the terminal value of, say, $100M in a sale to be made 20 years from now, you take 1.14, put it to the 20th power to reflect 20 years of discounted valuation…and you say 1.14 to the 20th power is about 13.7. So to get the present value of $100M 20 years from now using this discount rate, you would divide the $100M by 13.7…and that means that the $100M is roughly $7.3M of value today.
Yeah, that’s a big haircut.
The formula focuses a lot on near-term dividend distribution, and it’s really more interesting as a relic of original financial research than anything directly useful today.
And if you find this interesting, then...we may have a gig for you here at Shmoop Finance Central.
Related or Semi-related Video
Finance: What is a Dividend?1774 Views
Finance a la shmoop what is a dividend? well let's start with how [Bird flying with a bag]
dividends came to be well dividends are the result of a great and awesome quote
problem unquote.. what happened to corporations is they grew and became
dominant in their respective industries they retained so much cash profit even [man as a giant corporation crushing city buildings]
after building factories digging mines and smelting whatever they smelted well
that they couldn't figure out what to do with the cash so under a lot of [man with an open briefcase full of cash]
shareholder pressure and that is the common shareholders would threaten to
fire the Board of Directors, the fat and cash happy corporations just to begin to [common shareholders hitting the board of directors]
give it back to shareholders their owners who were in turn made happy by
that event and in many cases on the announcement of an increased dividend [share prices increasing and man shouts into a speaker]
policy share prices went up because of that whole investor happiness thing
there's a good structural reason for dividends to exist however they force [men bricklaying]
companies to be disciplined in their spending that is if companies aren't
disciplined, they don't have the money to pay the dividend and well when that
happens to a company basically everyone gets fired in most public companies [Donald Trump firing an employee]
dividends are viewed as a long-term commitment not as like a one-time thing
in fact during the Great Depression AT&T famously continued paying its dividend
without fail and many families relied on that dividend to make ends meet in the [family together eating dinner]
modern era companies in financial stress have even borrowed money just to make
sure they can pay their dividends to investors why well they believe that
when they get through the tough times they'll return to that massive [man running down a road sign posted under tough times]
profitability and they'll have a track record of continuing to pay dividends [oil machine working as cash piles up]
and that love is worth taking out a loan to pay a dividend the other big thing to
consider is that dividends are a very meaningful part of investment returns [dividends arrow pointing to investment returns]
which lousy financial journalists so often seem to forget many will decry the
era of the 70s as a lost decade looks like the stock market went nowhere from [man fumbling through a skip]
1968 to about 1980 right? well no it didn't go up but during that
period company's continued to pay their dividends and for the decade the [money going into a shareholders window]
dividend rate of the average S&P 500 company was about six percent so if
you've done nothing other than collect your six percent a year in dividends [Man collecting a 6% dividends]
well you would have been just fine you would have almost doubled your
investment money this way ignoring taxes from about nineteen sixty eight to [Man doubling his investment money from 1968-1980]
nineteen eighty and that's not bad for a lost decade
Up Next
How do you calculate rates of return? Calculating rate of return on an investment that pays dividends can be a bit tricky. You need to look at the...
What is an Accumulated Dividend? Accumulated dividends are dividends paid on cumulative preferred stock. They are referred to as accumulated becaus...
What is the Dividend Discount Model? Valuation of stocks can take numerous forms. One way in which one perspective on undervalued stocks is determi...