Dividend Discount Model

The dividend discount model is a more conservative variation of discounted cash flows, that says a share of stock is worth the present value of its future dividends, rather than its earnings. This model was popularized by John Burr Williams in The Theory of Investment Value. Williams wrote his book in the 1930s, when people were trying to establish a science of investing after getting burned by the irrational exuberance and accounting tricks of the previous decade. (Plus ca change, Jack.) Williams decided that reported earnings were way too nebulous to be trusted, like buying "bees for their buzz" instead of their honey, and that the only return you could really believe in was an actual check in the mail:

... a stock is worth the present value of all the dividends ever to be paid upon it, no more, no less... Present earnings, outlook, financial condition, and capitalization should bear upon the price of a stock only as they assist buyers and sellers in estimating future dividends.

Short version: you buy "a stock, by heck, for her dividends."

If you'd like to try this method out, you can use the regular calculator, substituting dividends for earnings.
(You presumably use a lower discount rate to reflect lower risk, since a dividend is more of a sure thing than reported earnings; the only guidance Williams gives here is that you use your desired rate of return as the discount rate.) You can also see the dividend discount formula - again, think "dividends" when the page says "earnings".

The dividend discount model can be applied effectively only when a company is already distributing a significant amount of earnings as dividends. But in theory it applies to all cases, since even retained earnings should eventually turn into dividends. That's because once a company reaches its "mature" stage it won't need to reinvest in its growth, so management can begin distributing cash to the shareholders. (Plan "B" would be for the CEO to pursue some insane acquisition, just to gratify his bloated ego.) As Williams puts it,

If earnings not paid out in dividends are all successfully reinvested... then these earnings should produce dividends later; if not, then they are money lost.... In short, a stock is worth only what you can get out of it.

Dividend Taxes

Williams mentions that the "rich men" of his day were starting to prefer dividends over capital gains, due to some recent changes in the tax code.

The Theory of
Investment Value
Fast-forward a few generations... and in May 2003 the tax rate on dividends was lowered to match that on long term capital gains. Whether or not any rich men were involved, the change is logical in the sense that companies that ought to be paying dividends will no longer have a disincentive for doing so out of concerns for the tax consequences to their shareholders. But one thing that probably won't ever happen is setting the dividend tax even lower than the long term capital gains tax, because doing so would disadvantage the stock of growing companies that really can't pay dividends yet - what would it mean for our economic growth if we made it harder for "growth" companies to raise capital?



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P/E Ratio
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Graham Formula
Dividend Discount
Buffett Formula (?)
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Also See
Valuation Formula
Stock Market Predictions
Measuring Investment Returns
Stock Market CAGR