Introduction
Say you're looking at a company's stock in the BSE or NSE and contemplating whether it will be worth your hard-earned rupees. Assuming it pays dividends, the Dividend Discount Model (DDM) will determine whether the stock is at its fair value. But what is the Dividend Discount Model, and how will you use it to make better investment decisions? Let's break it down into a format that suits you (an Indian investor looking to navigate the colourful but complex stock market).
Understanding the DDM Meaning
DDM stands for Dividend Discount Model. The DDM is a valuation process that values a stock based on the future dividends it will return. The thinking behind the DDM is simple: a stock's value is just the present value of its future dividends. Why? Because a rupee you earn tomorrow isn't as valuable as a rupee you earn today. After accounting for inflation and opportunity costs, our rupee is worth less in the future.
The DDM is a more beneficial model for Indian investors wanting to value stable dividend-paying companies, such as Hindustan Unilever, ITC, or Reliance Industries. These companies are characterised by their continual payouts and exist as a model to be dissected.
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The Dividend Discount Model Formula
The DDM formula is fundamentally a mathematical approach to valuation. To keep it simple, we will use the Gordon Growth Model, which assumes dividends grow at a constant rate eternally. Here is the dividend discount model formula:
Stock Value = D1 / (r-g)
D1: The next expected dividend per share next year.
r: The required rate of return (the profit you expect, usually determined by market risk).
g: The constant dividend growth rate.
Let's use a dividend discount model example made just for you. Suppose a company is TCS, which pays a dividend of ₹50 per share this year. You expect dividends to grow by 5% per year (g = 0.05) and you want a 10% rate of return (r = 0.10). The first step is to determine next year’s dividend (D1):
D1 = ₹50 × (1 + 0.05) = ₹52.50
Now, add to the DDM formula:
Stock Value = ₹52.50 / (0.10 - 0.05) = ₹52.50 / 0.05 = ₹1,050
TCS's current market price may be undervalued, indicating a buy if it's below ₹1,050. If it's above ₹1,050, you may want to wait.
When to Apply the DDM Model
The DDM is most effective when a company has a predictable history of dividends. In India, companies in sectors like FMCG, utilities, and banking can be predicted with some accuracy.
The DDM model is not meant for every context. It will struggle with companies that do not pay dividends (think of many tech startups) or with companies that pay dividends but do so unpredictably, like cyclical companies in the steel industry or real estate.
Important Inputs and Considerations
To use the Dividend Discount Model, you need to correctly input three inputs: the expected dividend (D1), the growth rate (g), and the required return (r).
Dividend Growth Rate (g): Estimating the rate at which dividends will grow means looking at the company's past dividend payments and the future dividend payment potential.
Required Return (r): The required return reflects your risk profile and the capital market environment. For example, many equity markets in India can be volatile, and thus, you could demand more for stocks that are deemed riskier.
Accuracy is Important: Small errors in g or r can vastly impact the stock valuation. For example, if you wrongly estimate a company's dividend growth rate and assume the wrong growth rate, you might inadvertently overpay for a stock without knowing it.
Variations of the DDM
Not all companies grow dividends at a consistent rate. For example, you could use a multi-stage DDM for a company such as Infosys in its high-growth phase. It will have high dividend growth for several years, stabilise in the future for several years, and then taper off as the company's growth matures. It is a more complicated method, but it reflects more accurately what happens in the real world.
Why the DDM Matters for You
As an investor in India, you may be able to pursue your wealth objectives, but likely with the weight of some uncertainties about your exposure to market risks. The Dividend Discount Model may make rationalising and valuing stocks easier while minimising the mass of noise investors contend with. While the model does not give you everything you need to value stocks (such as share repurchase information and capital gains), it is an important starting point for a dividend-oriented portfolio.
Before you emphasise any outcome derived solely from the DDM formula, be sure to compare your DDM to the results of other methods, including price-to-earnings ratios and discounted cash-flow models. Also, be vigilant about the macroeconomic environment in India, interest rates, and inflation to ensure you are comfortable with the assumptions derived from your required return and growth assumptions.
Conclusion
Do you want to use the DDM? Select a dividend-paying stock among shares listed on the Nifty 50 and collect the dividend history. You can use analysts' reports to estimate growth in dividends over time. Insert your values into the dividend discount model formula and then examine whether the market price aligns with your derived value for the stock. With further practice using the DDM in your experimentation, you will improve at identifying undervalued stocks in the Indian market.
You now know the Dividend Discount Model, and with practice, there is more to the DDM than number crunching: you are developing a disciplined investing approach that could continue to offer financial success over a time typical of Indian investment behaviour.