Dividend models are mathematical frameworks used to estimate the value of a stock based on its expected future dividends. These models are employed by investors and analysts to assess the attractiveness of an investment and make informed decisions. Two common dividend models are the Gordon Growth Model and the Dividend Discount Model (DDM):
1. Gordon Growth Model (GGM): The Gordon Growth Model, also known as the dividend discount model with constant growth, assumes that dividends grow at a constant rate indefinitely. It calculates the intrinsic value of a stock by dividing the expected dividend per share by the difference between the required rate of return and the dividend growth rate. The formula is as follows:
Intrinsic Value = Dividend per Share / (Required Rate of Return - Dividend Growth Rate)
This model is suitable for companies with a stable dividend payment history and a predictable growth rate.
2. Dividend Discount Model (DDM): The Dividend Discount Model is a more general framework that accounts for different dividend growth patterns. It values a stock by summing the present value of all future expected dividends. The formula is as follows:
Intrinsic Value = Σ (Dividend per Share / (1 + Required Rate of Return)^t)
3. Dividend Yield Plus Growth Model (DYGM): The Dividend Yield Plus Growth Model combines the current dividend yield with the expected dividend growth rate to estimate the total return on an investment. This model assumes that the investor will receive both dividend income and capital appreciation from the stock. It is often used as a simple valuation approach, especially for income-oriented investors.
where Σ denotes the summation, Dividend per Share represents the expected dividend per share for each period, Required Rate of Return is the investor's required return on investment, and t represents the time period.
The DDM allows for more flexibility in modeling varying dividend growth rates, such as multiple growth stages, declining growth, or irregular dividend patterns.
It's important to note that these models have assumptions and limitations. They rely on the accuracy of dividend projections, the stability of the dividend growth rate, and the appropriateness of the required rate of return. Additionally, these models do not account for other factors that may affect stock value, such as company fundamentals, market conditions, or investor sentiment. Therefore, it's essential to use dividend models as one tool among many in investment analysis and consider a comprehensive evaluation of a company before making investment decisions.
