Dividend Discount Model (DDM)

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It takes a very gifted student to simply be able to read a textbook and expect to pass an exam. For most students, a successful result requires them to Practice First, and you’ll see what I mean.

If you take a look at the first question, that you can view in the video, if the required rate of return were to increase, “How would it impact the intrinsic value of the stock?”. This question is even more challenging because, I promise you, you will not find a line in the text book that specifically says if the required rate of return increases you would expect the intrinsic value of this stock to fall – all else being equal. Instead, in order to answer this question right, you need to know which formula to use. You’re going to use the Dividend Discount Model and then you need to understand how one change in a variable would impact the intrinsic value of the stock.

If I were to ask you, “Why would you buy a share in a company? And why would you buy a common share?” Your response may be something like this. “If you’re looking for income, maybe you’re hoping to receive an annual dividend, you’re hoping that dividend increases with time, and that, overall, your return adequately compensates you for the level of risk that you’re assuming.” If you in the video you will see the Dividend Discount Model, which is “Div1”, which stands for dividend one year from now, over R, which is the required rate of return minus G, which is the growth rate. You want to pay attention to this formula because if you are asked to calculate intrinsic value of the stock the Div1 piece often confuses students and that is where they go wrong. Remember, you need the dividend one year from now.

You have to pay very special attention to the wording and the question. If they say today’s dividend is a dollar, for example, well then you’re going to have to increase it by the growth rate to find out what it will be a year from now. But if on the other hand if they say, “The dividend will be a dollar five” it is as though they are talking about next year. Then you would not have to increase it. So this is something you want to be aware of and pay special attention to on the exam.

Now, with all this in mind, let’s circle back and tackle that challenging question we looked at at the top of the video. The easiest way to tackle this question is simply to make up some numbers, calculate the intrinsic value, then increase the required rate of return, and calculate again to see how it would impact the answer.

Let’s assume that today’s dividend is a dollar, it is expected to grow by 2% per year, and the required rate of return for an investment of this risk level is 6%. Let’s start with the dividend one year from now. If it is $1.00 today and we expect it to grow by 2%, next year it will be a $1.02. So we divide a $1.02 into 4%, which is the required rate of return 6% minus the 2% growth rate, and then we calculate that all out. We get an intrinsic value of $25.50. Now let’s do what the question suggests and increase the required rate of return to 7%. We take $1.00 to the same dividend one year from now, except now we’re divided by 7% minus 2%. Once we calculate that all out, we get an intrinsic value of $20.40.

As you can see, if the required rate of return goes up, the intrinsic value of the stock would go down, all else being equal. So let’s go ahead and select answer B, and of course we are correct. To recap, here are the two learning points from this lesson (video). Number 1, if you are asked to calculate the intrinsic value of a dividend paying stock, that’s code word for use the Dividend Discount Model. Number 2, if you’re asked what would happen if one variable were to change, simply make up some numbers, calculate the answer, change that one variable, recalculate the answer, and you will see exactly what would happen. Thanks everybody. And since you stuck with me to the end of this video, it’s time for me to get paid with some likes. If you’re finding this content helpful, please let us know. So we can keep the content coming, subscribe to our YouTube channel and if you’re enjoying a video smash that like button.

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