Dividend Discount Model

Part of my job here at Parsec is to perform due diligence on the securities we cover, and I was just in the middle of reading up on Colgate when I thought to myself, “How can I possibly put this off for a little while longer? I know! I’ll write something for the blog.” I think I’ll talk about a little term people in the investment biz love to throw around – “undervalued” (and its sinister twin, “overvalued”).

I’m currently in the midst of studying for Level II of the CFA exam (I believe Dante includes this in the ninth circle of hell) which focuses heavily on security valuation. I’ve noticed that the answer to just about every question is, “discount the future cash flows.” The basic premise is that a security (or a company, or a capital project) should be worth the present value of its future cash flows. Present value means that, thanks to inflation, a dollar ten years from now will be worth a lot less than a dollar today. I guess that’s why my mom could ride a bus, see a movie, eat a hot dog, and buy her first house for just a nickel way back when. Therefore, a security (let’s take a dividend-paying stock, for example) should be worth something equivalent to all of its future cash flows (i.e., dividends) adjusted to today’s value.

How in the world do you calculate this, you wonder? Until recently, I thought it was a matter of going to the Bloomberg terminal and typing in a few commands. Thanks to my exam prep, I have learned that it can actually be calculated with something called a “pencil.” There are many ways to calculate fair value, one of which involves the dividend discount model, or DDM. The DDM requires several inputs, among them our good friend beta, swirls them all around and spits out a price. If the price (also called intrinsic value or fair value) is higher than the security’s current market price, the stock is undervalued. That means that the value of its future dividends in today’s world is higher than what you’d pay for it in the market. It’s like finding a pair of Manolos on Ebay for $100 when you know they retail for a good $400 more (I am still kicking myself with my cheap Payless shoes for letting those slip away). Conversely, if the DDM gives you an intrinsic value lower than the current market price, the security is overvalued. As with any mathematical model, the output is only as good as the input, and the resulting value estimation is sensitive to changes in any of several assumptions (EPS and dividend growth rates, beta, the market risk premium, etc.).

Well, I better get back to my Colgate research. I think it looks undervalued, but I need to do some more analysis. If anyone needs me, I’ll be under my desk discounting future cash flows.

Sarah DerGarabedian
Research and Trading Associate

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