The Two-Stage Dividend Discount Model

Benjamin Graham initially developed the Dividend Discount Model (DDM) presented in his book, “The Intelligent Investor”. DDM is an essential tool of fundamental analysis used to invest in undervalued securities. The premise underlying the calculation is that a company’s intrinsic (or real) value is the sum of future cash flows returned to an investor (dividends) discounted by a risk-adjusted rate.

The formula is relatively simple, excluding determining the risk-adjusted return rate.

At the time of publication of Graham’s calculation, a company’s willingness and ability to pay steady, increasing dividends over time was a sign of investment strength. In the latter part of the 1900s, company management favored high growth strategies, retaining earnings to fund expected growth. Investors rejected dividend payments in return for the rising price of their securities.

The Dividend Discount Model does not apply to growth companies that pay little or no dividends, approximately two-thirds of public companies. The model requires analysts to guess if, when, and how much dividends might be paid in the future — a questionable practice at odds with fundamental analysis logic. Despite the model’s difficulties, the underlying theory — a company today is worth the discounted cash flows of the future — remains valid.

A questionable assumption of the DDM is that dividends will grow into perpetuity at a steady rate. Experience indicates that companies progress through five stages during their existence, each with different effects on earnings and dividends.

The Two-stage Dividend Discount Model (DMM2)

Recognizing that dividend growth rates vary over the life of a company, the DDM evolved to include two stages of growth:

• Initial rate. During the growth state, dividends are often non-existent, then increasingly grow until the company matures.
• Steady rate. As growth slows, companies have fewer uses for cash, so dividends typically stabilize and continue at the same rate at maturity and initial stages of decline.

The two-stage dividend discount model recognizes this tendency and is more useful to analysts today.

The formula requires three estimates: the high growth rate g1, terminal growth rate g2, and the length of the high growth period N. Depending on assumptions, calculated intrinsic value can vary significantly. For example, a doubling of the dividend in five years is a Compound Annual Growth Rate (CAGR) of 14.57%. Higher growth rates combined with extended periods of accelerated growth will produce aggressive values, so it is crucial to be conservative to avoid being misled.

The example of AT&T illustrates the impact of different assumptions. While both calculations suggest that the intrinsic value of AT&T is higher than its market price, the figure in the right column would indicate that the market value is almost two and one-half times higher than its intrinsic value.

The growth rate in the dividend for the past five years is 1.61%. However, the assumption is that the dividend will increase by 10% each year for ten years before falling and remaining at 5% thereafter. Based on historical results, the growth rate is excessive.

The following table illustrates the DDM2 applied to a sample of growth stocks with AT&T. In each case, the dividend growth rate is the company’s average growth rate for the past five years. The discount rate is the sum of the dividend yield and the initial growth rate (r = Y + r). Since the increase in the AT&T dividend is low, the rate is the same for the initial and terminal growth rates.

Theoretically, the stocks to purchase are those whose DDM2 value is higher than its market value. In the model above, AT&T would be the most logical purchase, followed by IBM and 3M, respectively. Since the Hasbro and Intel market values are higher than the DDM2 values, they should be avoided.

Limitations of the Model

No valuation model is perfect or applicable in all situations. The specific weaknesses of DDM2 include

• Identifying the initial growth period. Defining the exact points that companies move from their growth phase to maturity and then decline is difficult. Furthermore, the model assumes that the growth rate will decrease to a stable level after this period, increasing the intrinsic value of an investment as this period is extended.
• Abrupt phase transitions. The model assumes that the growth rate is high during the initial period and transforms instantly to a lower stable rate at the end of the growth period. While possible, a gradual shift from high growth to stable growth is more likely.
• Focus on dividends. Since the model focuses solely on dividends, the values for companies who retain cash, i.e., not paying out dividends they can afford to pay, leads to under valuations of high profit, high growth firms. The model works best for firms that pay out most of their residual cash flows — cash flow left after debt payments and reinvestment needs — as dividends.
• Dependence on current, accurate data. By necessity, fundamental analysis assumes a static environment. However, conditions are in constant flux, with prices continually changing and affecting ratios, models, and conclusions. Market action can negate a decision before action is possible.

Use of Automated Investment Analysis Services

There are approximately 630,000 companies whose securities are publicly traded in the world. More than 40,000 are listed on the world’s stock exchanges. Almost 2,400 companies trade on the New York Stock Exchange, and the Nasdaq covers another 3,100. Each company produces reams of operational and financial data, including quarterly and annual reports.

Trying to identify purchase opportunities amid the incoming data is a Herculean task, impossible without the aid of computers, sophisticated software, and online access. Once purchased, the dynamic nature of economic and investment conditions requires constant surveillance and decisions to hold or sell existing investments, stay on the sidelines, or aggressively pursue rare opportunities.

Fortunately, companies like wealthX are available to collect information and crunch numbers — using tried and true fundamental analytic tools augmented with Artificial Intelligence (AI) — for time- or expertise-challenged investors. The company’s proprietary system focuses on companies with five years of exceptional performance, calculates intrinsic values based on a combination of proven models, and uses a safety margin of 10% to identify stocks and the range of prices where they justify a purchase. Extensive back-testing has confirmed the validity of the company’s approach, with its use likely to produce better than average returns.