Discount model part 3: Dividends

In this part of the article series about the discount model, I will discuss the dividends discount model (or DDM). In previous articles in this series, the basis and calculation of the discount model and the cash flow discount model are described.

In this article, I write about the pros and cons of the use of the dividends when calculating the discount of shares of a company. Besides that, I also explain the specific principles and attention points for the dividends discount model. I will also discuss the origin of the discount models (not specific the dividends discount model) and the investors that use the discount model.

Dividends as indicator

As cash flow of a company is the difference between the incoming and outgoing cash of a company, dividends is the yearly income of an investor. You can see dividends as the cash flow from investment activities for an investor. When a company or share is valued by discounting the expected future dividends, the actual income from the shares is valued. This is an important difference between the cash flow discount model and the dividends discount model.

Advantage of the dividends discount model

The dividends discount model has one important advantage compared with other discount model calculations: the income of an investor is being used to calculate the value of a share. Therefore it is not important what is being done with the cash flow or profits of a company. Management can spent it in their own way, as long as they pay out the dividends every year. Payment of dividends is thus priority one for the company.

Disadvantage of the dividend discount model

As mentioned, the dividend discount model does not use the income of the company for the calculation of the value, but the income of the investor. The income of the company can (and will) differ from the income of an investor. Only a few companies pay out the total profits the company made. Therefore the total dividends do not match the profits or cash flows. Dividend payments are even deducted from the net cash flow, because dividends is money flowing out of the company. And sometimes, dividend payments are higher than the profits made.

A second disadvantage is that not every company pays out the dividends using the same calculation method. Some companies pay out a previously determined part of the profits as dividends. Other companies increase the dividends each year with a predefined percentage, regardless the profits made. And again other companies will only pay dividends when they do not find anything better to spent their money on. This is a reason why the dividend discount model should mainly be used when you are interested in dividend payments and the growth of these dividends.

Principles and attention points

The main principle of the dividends discount model is that the dividends should be paid by the company every year. Besides that, a second principle is that the dividend payments for the coming years will grow at the same rate as the mean growth of the previous years. When one of these principles is not applicable, then the future income of investors is at risk. The value calculation of the company based on the dividend payments will no longer be valid.

Another important principle (and attention point) is that the company can sustain the dividend payments. Dividends above the cash flow and profit cannot be paid each year. This also causes the risk that the dividends will no longer be paid.

Origin and usage of the discount model

The discount model (and not specific the dividends discount model) is being used for a long time by investors to valuate the shares they want to invest in. Well known investors that use or have used the discount model are Warren Buffett, Benjamin Graham and John Burr Williams. One of the founders of the discount model method is John Burr Williams. He used the cash flow to value the net present value of a company. The goal of using the discount model for John Burr Williams (and also for Warren Buffett) is to find undervalued shares or shares with an high growth potential.

During the years, variations on the discount model have been added. The different calculation methods have different backgrounds and methods of use. As discussed in this article, the dividends discount model has the principle that the income of an investor is the most important. This is unlike the cash flow discount model (or discounted cash flow method) or the profit discount model, at which the income of the company is the most important parameter.

The discount model series

In part 1 of this article series, the fundamentals and calculation of the discount model are explained. In part 2 of this series, the cash flow discount model (discounted cash flow) is discussed.

In the next and final article of this series, the discount calculation based on the profits of a company will be explained.

If you want to use the discount model, try the discount model calculation tool on this website.