Dividend Discount Model Calculator

Tool Overview: Dividend Discount Model Calculator

Key Concepts Behind The Model

This multi stage dividend discount model calculator uses a modified dividend discount model to calculate the expected value of a stock. This approach values the stock at the discounted value of the cash flows from the stock (dividends and future stock price). The numbers shown in this example are from a real company (3M, as of December 2016). We actually present a range of values, calculated this two ways:

• Old School - Strictly Dividends
• Alternate Approach That Uses Ben Graham's Intrinsic Value Formula

Assumptions are important to this model.There are three major sets of assumptions used to develop these estimates:

• Earnings Growth - Short Term and Long Term
• Future Dividend Payout
• Rate of Return Expectations

Growth is tricky and easy to overestimate. The multi stage dividend discount model calculator gives you the ability to set a period of fast growth followed by reversion to a more typical rate of earnings growth. We split the growth estimate into two portions - an estimate for the next 5 years and a "longer term" estimate which is intended to be more conservative. Feel free to estimate whatever you want for the next five years - the model is fairly flexible and can handle it. We suggest long term growth rates be set relatively near your expected growth rate for US GDP. This is currently expected to be between 2% and 3%. The key is long term vs. short term; companies rarely sustain outperformance for more than 5 - 10 years. If the industry is of growing importance (technology, biotech) then bump it up a little (%5 - 6%), if the industry is in decline, bump it down to zero or a negative number. In the case of 3M, they have have delivered 7%+ earnings growth fairly consistently; we bump this down to 5% for future years. While this is above GDP, they have a history of being innovative and good stewards of investor capital.

Your estimate of the future dividend payout affects the value of classic dividend discount model valuation. We default this to 60% (fairly generous, assumes modest capital investment to sustain growth). If the company is well established and is regularly paying a dividend, feel free to update this to match the actual history. For non-dividend paying companies, this is a reasonable starting point. Basically, this assumes a company grows for 5 years and then returns excess cash to investors. 3M's actual dividend payout ratio of $4.44 / $7.84 => 56% is close enough to our default of 60% that we don't change with it.

Finally - the rate of return expectations. Since we're current in a historically low interest rate environment, we split this into three parts.

• Long Term Corporate Interest Rates
• Equity Risk Premium
• beta - stock volatility

The interest rate is the "risk free" version of giving money to companies. Corporate bond holders don't have access to their money for long periods of time. Yes, they can sell to another investor - but that person won't have access to the money either (and will price accordingly). It's worth noting that we're at a historic low in terms of interest rates and that is affecting many other stock valuation metrics.

The equity risk premium is the additional return we expect to receive from owning stocks vs. bonds. We set this at 5% (and recommend you don't change it). This is in line with historical experience.

Finally, we have a way to adjust our expectations of a stock for the level of risk associated with its industry. Certain industries are very sensitive to market events and stocks will rise/fall faster than average. Other industries are less sensitive. We use the beta metric to tweak this up and down. You can find beta for a stock in the quote data on yahoo finance (and a few other sources). This is admittedly a simple approach - you can also build your own betas using industry statistics and adjusting them for the company's capital structure (corporate finance style). 3M's current beta of 1.02 is close to our number, so we don't change the default.

Sharp eyed readers will ask why we're not using 11% as the expected return, like most other folks involved in the stock market. Simple - that performance was done in an environment with higher interest rates (usually 5%+). As the interest rate declines, expected equity returns should decline as well.

As you will see, the model calculates a range of $146 - $191 for 3M. They are currently trading at $178, which is slightly on the high end of this.

Getting the Information: My two preferred sources for stock data are Yahoo Finance and Seeking Alpha. For Yahoo Finance, pull up a quote page and look at the tabs for "statistics" and "analysts". Use that to fine-tune your assumptions. Incidently, analyst growth expectations are almost always too optimistic - as a rule of thumb, I take the greater of 50% of the expected 5 year growth number or 100% of the past five year "actual growth". Unless we see an obvious reason why the situation has changed (long term).