Seeking Alpha

How I Use The Dividend Discount Model To Make Smart Investing Decisions

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Includes: CSX, KSU, UNP
by: The Dividend Guy
Summary

There is a common mistake most investors make: they study the dividend discount model with great caution and then use it as a valuation tool.

What the DDM really gives you is the value of a money printing machine.

The DDM or the Discounted Cash Flow Model are simply giving you a theoretical value for future dividend (or free cash flow for the DCF).

Focus on finding great companies increasing their dividend year after year and let the share price be a secondary element in your decision.

The Dividend Monk contains a multitude of articles about the dividend discount model (aka the DDM) and how to use the famous Gordon Growth Model. Most articles I read (from this blog or elsewhere) focus on the calculations, how to put the numbers in the DDM formula. Those articles are lengthy and include academic references to the Capital Asset Pricing Model (CAPM), the beta and risk-free returns. After a couple of reads, you become academically educated in explaining the DDM formula and its components. But do you really know how to use the dividend discount model to make smart investing decisions? This article will tell you how I interpret the results of my calculations and how I use it in real life.

First, forget about valuation, the DDM is not about the price you pay

There is a common mistake most investors make: they study the dividend discount model with great caution and then use it as a valuation tool. After all, this is what the formula is about, right? Determining the fair value of a stock considering future dividend payments to be received. This is very good for financial theory fans who spend their lives studying the market but rarely invest a dollar in a single stock.

What the DDM really gives you is the value of a money printing machine. Imagine you wish to make 9% return on your investment (read discounted rate of return). You select a dividend stock. You get its dividend payment from any free financial websites and you guess to the best of your knowledge how the company will increase it in the upcoming years.

Let's run some numbers in the Dividend Discount Model

The numbers used for this example are as follow:

  • Annual dividend payment per share: $1.52
  • Expected (read best guess) dividend growth rate: 6.00%
  • Discount rate (expected return on your investment): 9.00%

Plug all numbers in this calculator and get a magical stock valuation!

What you really get from the DDM calculator is the price you should pay if you were to buy a money printing machine paying $1.52 per year with a dividend growth rate of 6% while you want to make a 9% return on your investment. In this case, the price of your money printer is $53.71. If the stock is trading at $70 on the market, this means you are paying too much. If the stock is trading at $40, you technically have found a hidden gem at great discount.

If you buy the stock at $40, does it mean it will go up to $53.71 within the next 12 months? 18 months? Or even 5 years? Nope! The DDM is not giving you how much the stock will be worth on the market on any day.

Bummer.

All those years you have been calculating "fair value" for stocks and they never reach them. Now you know why. The DDM or the Discounted Cash Flow Model (DCF) are simply giving you a theoretical value for future dividend (or free cash flow for the DCF). This value will not likely translate in the real world for many reasons:

  1. Your assumptions on the dividend growth and the discount rate are at best wild guesses. Nobody predicts the future, sorry!
  2. Both models are highly sensitive and can give completely different valuations depending on your guesses… I mean assumptions. The example above showed that a 1% difference in the discount rate or the dividend growth rate could make the difference between a valuation at $162.64 (discount rate of 8%, growth rate at 7%) and $31.92 (same calculation but with a discount rate of 10% and growth rate of 5%).
  3. Several events/factors outside and inside the company will affect its value on the market (do you really think the market cared about the DDM in 2008?)

How I use the Dividend Discount Model to make investment decisions

Regular readers will know that I'm not a big fan of stock valuation. I'm a big fan of finding great dividend growth stocks and buying them on the spot. Why do I bother writing about the DDM then? Because I use it in a different way. In a way that helps me to make smart investment decisions.

I'll tell you how I use it in a moment, but first, let me ask you this:

When you make a purchase, how do you differentiate two items?

Imagine you are at Best Buy and you wish to buy a TV. How will you differentiate the two 58'' smart TVs in front of you?

Chances are you don't know how much Best Buy paid for them. Therefore, you don't know if there is a bigger commission on one or another. What you know are the TV characteristics and their price. If you have two nearly identical TV in front of you offering the same quality and characteristics, chances are you will take the cheapest one.

This is exactly how I use the dividend discount model. For example, I look at my asset allocation (you can see my complete dividend portfolio on my other blog) and I determine I need to increase my exposure to the industrial sector. I use my stock filter and pull out a series of great candidates. Let's imagine three of them are businesses in the railroad sub-sector. While each company shows a slightly different profile, I might get stuck in a "analysis by paralysis" moment for a while.

Making the investment decisions with the Dividend Discount Model results

If I'm stuck and I don't know which stocks to pick, I can definitely compare their value as a printing money machine. To continue with my example, I will use a two-level dividend discount model calculator. This calculator will give me a more "accurate" valuation. Imagine I have the following stocks on my list:

Kansas City Southern (NYSE:KSU) with a dividend payment of $1.44 ($0.36/share quarterly) and a current price of $124.35 (data as of August 21st after the bell).

Union Pacific (NYSE:UNP) with a dividend payment of $3.88 ($0.97/share quarterly) and a current price of $168.70.

CSX (NASDAQ:CSX) with a dividend payment of $0.96 ($0.24/share quarterly) and a current price of $65.34.

Looking at the three options, UNP is the only one with a valuation close to its current share price. Does this mean that UNP's shares should drop from $168 to $149 before pulling the trigger? Absolutely no. I used the DDM to compare three similar investments and see which one shows the best price for a dividend printing machine.

A few tweaks to the dividend discount model

The above-mentioned example isn't perfect, far from it. Each company is different and presents metrics of their own. In this example, I should have used a lower dividend growth rate for KSU since the dividend has remained stagnant for the past three years while UNP increased it by 76% and CSX by 33%.

However, even if all three companies would grow the dividend in a similar manner in the future, my calculations show that UNP is the best in class in terms of dividend growth vs. the price paid. Once again, I didn't get a market value from the DDM, I only got the price I should be paying if I'm looking for a dividend printing machine. As a dividend growth investor, this is exactly what I'm looking for.

I also like to simplify my investment process when it comes down to the usage of the DDM. I don't use the classic CAPM to determine the discount rate. I use a simple rule of three different rates:

9%: The company is well-established, a leader in its industry and shows stable numbers. Example: railroads companies.

10%: The company is well-established, a leader in its industry but shows an element of risk or fluctuation. Example: Apple (NASDAQ:AAPL)

11%: The company shows important flaws or imminent menace to their business model. Example: could be in the energy sectors as their dividend is highly dependent on commodity prices.

The key here is to use similar discount rates for similar company situations. This is how making comparison with the DDM could work.

A few other observations could be made to improve my decision-making process:

  1. Looking at the current yield. UNP is clearly a winner.
  2. Considering past dividend growth. Then again, UNP is a clear winner.
  3. Calculating their payout ratio and cash payout ratio. UNP shows the highest, but they are at 40% and 47%, respectively.

Final thoughts on using the DDM

I see the dividend discount model as a great tool to give a direction in my investment process. The valuation calculated by this model will not likely prove me wrong or right, but it will give me a clear idea on what the dividend of this company is worth.

Making a sell or a buy decision because the DDM comes out overvalued or undervalued doesn't make any sense. After all, if you are part of the dividend growth investor crew, you know you buy shares for the long term. Therefore, focus on finding great companies increasing their dividend year after year and let the share price be a secondary element in your decision.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.