Dividend Discount Model
Dividend Discount Model Calculator is an online tool that calculates the value of equity shares in terms of present value. This model assumes that the present value of equity is equal to all its future dividends.
The model states that the dividend will affect the market price of shares. The dividend discount model talks only about dividends. It does not take into account the concept of capital appreciation. According to this model, shareholders are more interested in dividend distribution at a constant rate each year rather than retention of profits.
- Dividend Discount Model
- Formula for Calculating Dividend Discount Model
- About the Calculator / Features
- How to Calculate using Dividend Discount Model Calculator
- Example of Dividend Discount Model
- Interpretation of Dividend Discount Model
The major assumption under the dividend discount model is that the growth rate of dividend is constant.
Formula for Calculating Dividend Discount Model
The formula for calculating the value of stock through the dividend discount model is:
Value of Stock = Expected Dividend Per Share / (Cost of equity – Dividend Growth Rate)
About the Calculator / Features
This calculator calculates the value of stock effortlessly when the user provides the following data to the calculator.
- Expected Dividend Per Share
- Cost of Equity
- Dividend Growth Rate
How to Calculate using Dividend Discount Model Calculator
In order to calculate the value of a stock using the calculator, the user simply has to insert the following data into the calculator.
Expected dividend per share
It is generally denoted by D1. It is the dividend expected by shareholders. Generally, matured companies with constant growth use this model. The expected dividend per share can be calculated with the help of the following formula.
D1 = D0(1+g)
where D0 = Dividend of the first year
g = Dividend growth rate
Cost of equity
It is denoted by ke. The cost of equity can be defined as the minimum rate of return to be earned to pay off dividends to the shareholders. There are 4 methods available to calculate the cost of equity.
- Dividend method (no growth model)
- Constant growth model (Gordon model)
- Earning model
- Capital Asset Pricing Model (CAPM)
Calculator to calculate the cost of equity using constant dividend growth model – Cost of Equity (Constant Dividend Growth) Calculator
Calculator to calculate the cost of equity using capital asset pricing model – Cost of Equity (CAPM Model) Calculator
Dividend growth rate
Shareholder expects a constant growth in dividend each year. This expected growth rate is the dividend growth rate.
Example of Dividend Discount Model
Let us try to understand this concept of the dividend discount model with the help of an example. Mr. X is contemplating the purchase of 100 equity shares of a Company. His expectation of return is 15% before tax by way of dividends with an annual growth of 10%. The Company’s last dividend was 5 per share. The market price of a share is `102 per share.
Calculate the value of equity shares after the announcement of dividend
Value of Stock = 5.5 / (0.15 – 0.10) = 110
Here, D1 = 5(1+0.1) = 5.5
ke = 0.15
g = 0.10
Interpretation of Dividend Discount Model
The dividend discount model gives the investor the price of the stock he is intending to invest in. If this value is higher than the market price of a stock, investor should invest in the stock as it is undervalued. Similarly, when the market price is higher than the value calculated through this model, the investor should sell the stock as it is overvalued. In the example above, the market price of an equity share is lower than its price under the dividend discount model. Therefore, the investor should purchase the shares.
The main drawback of the dividend discount model is that it assumes that the dividend constantly grows each year which is not possible in the real world. Secondly, it completely ignores the capital appreciation that can fetch a better return to the shareholder than by distributing dividends.