The dividend discount model, simply explained
As a shareholder, what you mainly get from a company is dividends. The dividend discount model therefore values a share by all the dividends it is expected to pay in the future, discounted to today. It suits companies that pay out reliably and with rising amounts.
The idea
Think of a share as an orchard you never sell. It is worth exactly as much to you as the harvest it brings you over the years. For a share, that harvest is the dividend.
The American economist John Burr Williams wrote this idea down as early as 1938: the value of a share is the sum of all future dividends, each discounted to today. It is the same logic as in a DCF – except that what counts here is not the company's free cash flow, but the part of it that actually reaches you.
The formula
If the dividend grows at a steady rate year after year, the endless sum can be put into a short formula. It is named after the economist Myron Gordon:
- D1
- next year's dividend, i.e. today's dividend × (1 + g)
- r
- return you require, for example 8% = 0.08
- g
- long-term growth of the dividend, for example 5% = 0.05
As with the terminal value in a DCF: g must be smaller than r. Otherwise the formula does not give a meaningful value.
The worked example
The made-up Dividend Inc. pays a €3 dividend per share today. We assume the dividend rises by 5% a year for good, and we require a return of 8%.
| Step | Calculation | Result |
|---|---|---|
| Dividend today | €3.00 | |
| Dividend next year | €3.00 × 1.05 | €3.15 |
| r − g | 8% − 5% | 3% |
| Fair value per share | €3.15 ÷ 0.03 | €105.00 |
If the share costs less than €105, you get more than the required 8% a year under these assumptions. If it costs more, less.
How sensitive the result is
Because only the small gap between r and g sits in the denominator, the model reacts strongly to the assumed growth. All else equal:
| Growth g | r − g | Fair value |
|---|---|---|
| 4% | 4% | €78.00 |
| 5% | 3% | €105.00 |
| 6% | 2% | €159.00 |
One percentage point more or less growth moves fair value by a quarter to a half. That is why a cautious value for g pays off – rather the one the company can sustain for good than the one from its last good years.
When the model fits
The dividend discount model suits companies that have paid out reliably for many years and steadily raise their dividend: utilities, large consumer goods makers, many banks and real estate companies. For them, the dividend is a good mirror of what the business yields over time.
It does not work for companies that pay out little or nothing. Many growing companies prefer to put their money into the business or buy back shares. Their value is still there – the dividend just does not show it. Then a DCF is the better way.
Is the dividend safe?
The model assumes the dividend keeps being paid and keeps growing. So check where it comes from. A good guide is free cash flow: if it covers the dividend over many years, the dividend is earned. If a company pays out more than it takes in, or borrows to do so, the dividend cannot rise forever.
Three common mistakes
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Frequently asked questions
What return r should I require?
The minimum return you want for the risk of this share. It follows the same thought as the discount rate in a DCF: the more uncertain the company, the higher.
What growth g is realistic?
In the long run, a dividend can hardly grow faster than the company itself. A look at dividend growth over the last ten years and at earnings growth helps to find a cautious value.
What about share buybacks?
Some companies prefer to return money through buybacks rather than dividends. The classic model does not see that part. For such companies, a DCF fits better.
Is a high dividend yield good?
Not automatically. A very high yield often arises because the share price has fallen sharply – for example because the market expects a cut. Check whether the dividend is covered.
Not investment advice. All content is for informational and educational purposes only. Dividend Inc. is made up.