For every stock analysis I do on my blog or for my portfolios, I always add a section on valuation. This article describes how I use the dividend discount model for my stock analysis.
To be honest, the evaluation part of my analysis isn’t my favorite … and neither is it the most important in my opinion. I’d rather work on my investment thesis and evaluate potential risks than shake my crystal ball and give stocks a dollar value. Is it because I’m badly rated? Not really. The problem is, I am aware that regardless of the method I use, there are serious limitations that could result in two investors using the same model but getting completely different results. Today I’m going to take a look at the limitations of the Dividend Discount Model (DDM) and how I deal with them.
How the dividend discount model works
The reason I like using the DDM in my work is because the formula is simple and effective. The purpose of this model is to provide a value for future dividend payments. It basically gives you the value of your “money machine” based on how much it should pay you back in the future. The model is based on the following formula:
P. is the price of the share, D1 dividend is expected next year, R. is the rate of return (discount rate) and G is the dividend growth rate. Therefore, to complete the formula, you need to “simply” determine the discount rate and future dividend growth rate, since you already know the dividend payable.
How can you make mistakes with a simple formula? Unfortunately, nothing is easy in finance, and while the DDM sounds simple, it has some shortcomings.
Model error with dividend discounts
Regardless of the method you use, the first mistake of all computational models is the same: the model is as good as its input. You can enter any type of numbers you want and the results may vary. This is why it is so important to understand the specific errors for each model you are using. Here is the list for the DDM:
Constant dividend growth rate
Based on the original formula (also known as the Gordon Growth Model), the calculations are based on constant dividend growth over time. This assumption is completely wrong and probably never will in real life. For the remainder of this article, I’ll be using a well-known dividend king: 3M Co (MMM). Here is the MMM dividend growth rate over the past 30 years:
Source: data from Ycharts
While MMM has been increasing its payout for 58 straight years, you can see that the dividend growth rate has fluctuated widely over time.
Digging into the history of the company’s dividend growth rate can help you get a better idea of the average. After looking at how management increased their payouts, you can also see how sales and earnings have grown lately. To improve your accuracy for dividend growth rate, you can also use a two-stage DDM. This allows you to choose an initial dividend growth rate for a period of time and a terminal growth rate for long-term payouts.
What dividend growth rate?
On the other hand, we have reached another difficult-to-determine value. Should you use last year’s growth rate, which is very close to the current business situation? Or should you think about it and consider a bigger growth story?
If you’re using the two-tier DDM, the first number should be close to what the company has been through for the past 5 years, and the terminal rate should more reflect the overall history of the company’s growth rate. This isn’t an easy task, but let’s take a look at how MMM increased its dividend:
- 5 years: 14.77% annualized return
- 10 years: 9.367% annualized return
- 20 years: 7.73% annualized return
- 30 years: 8.01% annualized return
When you combine this analysis with the current company’s payout and cash payout ratios, you should have a very good idea of whether or not management has enough leeway to continue the rate of growth over the past 5 years. MMM currently has a payout rate of 50.78% and a cash payout rate of 50.92%. Last year MMM increased its dividend by 5.85% and last year the growth rate was 8.29%. You can then see that the 5 year dividend growth rate is not going to be a good choice for the next 10 years.
A more reasonable growth rate of 8% sounds more appropriate. As a terminal growth rate, I tend to deal with conservative values. In this case, I think it’s fair to assume that MMM can maintain a growth rate of 6%, considering the 30 year annualized growth rate is 8%.
Different discount rates applicable
There are various discussions about which discount rate to use. I mean what kind of return on investment do you want? Or do you expect This question leads to a very subjective answer. If you are overly generous (e.g. looking for a low discount rate), you will find that the entire market is for sale all the time. On the other hand, if you are too greedy (e.g. looking for a high discount rate), you will never buy anything … other than a value trap!
According to finance theory, we should use the Capital Asset Pricing Model (CAPM). This is another formula used to describe the relationships between the risk of an investment and its expected return:
As you can see, in order to determine the discount rate you now need to determine several other variables. The risk-free rate of return refers to the investment rate at which there is practically no risk. It is usually referred to the 3 Month T-Bill Return. From August 4thth In 2017, Ycharts shows the 3-month T-Bill rate at 1.06%.
In the future, the beta determines how a security fluctuates compared to the overall market. A beta of less than 1 means that the security fluctuates less than the market and vice versa. You can easily find Stock Beta on free websites like Google Finance. For example, MMM Beta is set to 1.06 as of August 4thth 2017.
The final metric used is the market’s expected return. This number could be debated a lot. If you look at the total return on the S&P 500 over the last 5, 10, 20 and 30 years, you get completely different numbers:
- 5 years: 14.63% annualized return
- 10 years: 7.93% annualized return
- 20 years: 6.89% annualized return
- 30 years: 9.90% annualized return
I would tend to discard the 5 year and 30 year results. The last 5 years have not included a full business cycle, whereas 1987 was very different, and I don’t think we can expect such growth in the future. I think the answer is between 20 and 10 years. To be fair, we’ll use the average of both. 7.41%.
Here what should the discount rate be: 7.79% = 1.06% + 1.06 * (7.41% -1.06%)
This is a pretty sensitive model
We are now ready to use our two tier DDM and see if MMM is trading at an interesting value or not. Using the numbers described in this article, we have the following data:
|Input descriptions for the 15-cell matrix||INPUTS|
|Enter the last annual dividend payment:||$ 4.70|
|Enter the expected dividend growth rate for years 1-10:||8.00%|
|Enter the expected terminal dividend growth rate:||6.00%|
|Enter discount rate:||7.79%|
Then if you do the calculation, you get a fair value of $ 331.30.
|Discount rate (horizontal)|
|20% premium||$ 907.05||$ 397.56||$ 253.41|
|10% premium||$ 831.46||$ 364.43||$ 232.30|
|Eigenvalue||$ 755.87||$ 331.30||$ 211.18|
|10% discount||$ 680.29||$ 298.17||$ 190.06|
|20% sale||$ 604.70||$ 265.04||$ 168.94|
We all agree that MMM is NOT 60% undervalued right now. The DDM gives us a completely ridiculous value with a discount rate of 7.79%. Please note that I have selected dividend growth rates that are in line with or below MMM 5, 10, 20 and 30 years. So I can’t really reduce these numbers. However, if you look at the chart, my Excel spreadsheet gives me two more results with a discount rate of 6.79% (-1%) and 8.79% (+ 1%). Interestingly, the intrinsic value of $ 211.18 already seems more appropriate. However, you can see how sensitive the model is when 1% makes the difference between $ 755, $ 331, or $ 211 for the same stock.
The solution, obviously, is to put everything in perspective. Should I expect a higher return on the market and go back to my CAPM calculation? Because if my discount rate is closer to 9%, I get a rating closer to what MMM is trading for. My solution to this problem is Do not use CAPM… huh? Yes, you read it right, I’m using a different system based on the rest of my analysis.
Instead of using historical numbers and academic concepts, I decided to use three different discount rates depending on the company’s situation:
9%: The company is well established, a leader in its industry and has stable numbers. Example: railway company.
10%: The company is well established, an industry leader, but has an element of risk or volatility: Example: Apple (AAPL)
11%: The company has important shortcomings or imminent threats to its business model. Example; could be in the energy sector as its dividend is heavily dependent on commodity prices.
With the help of my Excel spreadsheet, I then calculated 3 different discount rates and 10% – 20% safety margins at the same time. It helps give the company the right rating.
As you can see, we could all use the DDM for the same company and get different answers. In the end, your rating will be as good as your assumptions. Unfortunately, one point up or down in the calculation matrix and you can immediately switch from “BUY” to “SELL”.
Because of this, it is important to have a margin of safety and a number of calculations in place to get a clear idea of whether you should buy, hold, or sell the stock you are analyzing. The tool I use to calculate the DDM is in the Dividend Toolkit. The toolkit also includes a full section on using the DDM and other valuation methods such as the discounted cash flow model.
Regardless of how much time you spend on your valuation methodology, it is likely not the reason for your success or failure as an investor. What really decides whether you can manage your own portfolio is your ability to develop a complete investment process and then adhere to it. You can read about my detailed investment process here. It gives you a good head start!