Dividend Discount Models
The Dividend Discount Model (DDM) is the key valuation technique for dividend stocks.The most straightforward form of it is called the Gordon Growth Model. This guide explains how it works and the streamlined way to use it.
Determining the fair value of a company means using Discounted Cash Flow Analysis (DCFA). DCFA, put simply, states that the present value of a company is equal to the sum value of all future cash flows that the company produces. But each future cash flow must be discounted to translate it into today’s dollars. This is logical: the purpose of a business is to produce cash flows, so the value of the business is equal to the sum value of all future discounted cash flows.
By discounted, what I mean is that due to the time value of money, a payment in the future is worth less than the same payment today. For example, if you can earn a 10% rate of return on your money over time, then a payment of $10,000 one year from now would only be worth $9,091 to you today, because if you had $9,091 today, you could invest it at a 10% rate of return and turn it into $10,000 a year from now. ($9,091 multiplied by 1.10 equals $10,000) So, the discounted version of, or the net present value of, $10,000 one year from now, is equal to $9,091.
Similarly, if you were to receive $10,000 in five years, then this sum would only be worth $6,209 to you today, because you could take $6,209 and compound it by 10% annually to get $10,000. ($6,209 multiplied by 1.10 five times in a row equals $10,000). So, the discounted version of, or the net present value of, $10,000 five years from now, is equal to $6,209.
To value a business, you would take the discounted values of all future annual expected cash flows, sum them together, and that’s the fair value of the business. You’re trading a present sum of money (the fair value), for a future series of expected cash flows, but each cash flow has to be translated into today’s value to take into account the time value of money and your target rate of return on your current money.
The inputs you need are the current free cash flow figures, the projected growth rate of those cash flows, and your target rate of return to use as the discount rate.
Obviously there’s a mix of art and science involved here. If appropriate inputs (expected cash flows) are used, the output (current intrinsic value) is objective. But since the inputs are future expected cash flows, there is uncertainty in those figures and it requires reasonably accurate estimates to be useful.