# Dividend Discount Model’s Four Essential Steps

The Dividend Discount Model’s four essential steps are summarized below. The purpose is to provide a quick reference for this valuation, give an example, and offerÂ a spreadsheet template to facilitate calculations and sensitivity analysis.

Weâ€™ve covered how to value a business with a Constant Dividend Growth Rate and, with a Multi-Stage Dividend Growth Rate. Â With this fundamental understanding in place, we can now boil it down to the Dividend Discount Model’s four essential steps.

The key things to remember about using the Dividend Discount Model:

1. It values companies paying dividends;
2. Usually mature companies with a history of consistent dividends;
3. It assumes the company will continue a dividend into the future.

Now, letâ€™s go through the essential steps for calculating intrinsic value using the valuation on Brookfield Infrastructure as an example.

#### Step One: Calculate the Present Value of the Multi-Stage Dividend Growth

We manually calculatedÂ the present value to gain a fundamental understanding of how the formulaÂ works. Here we incorporate the formulas into an Excel spreadsheet to speed up the calculations and reduce potential for errors.

It is recommended that you take the time to set up a spread sheet to automate calculations forÂ this method. Â Columns G, H and I show the formulas used in Columns C, D and E for this example.

We start with an estimate of the per share dividend growth for each year. In the Example Table Column C, we assume 7% growth for 10 years. Starting with a \$1.74/share dividend in Year 1, Column D shows the growth over time.

Then, we discount each future yearâ€™s dividend back to the valuation date (Year 0). We use the 10% opportunity cost as the discount rate in this example. Column E in the Example Table shows the results.

After that, we add them together to determine the total of the discounted dividends during the multi-stage growth phase shown in Cell E16.

Example Spreadsheet, Click on it to enlarge.

#### Step Two: Calculate the Present Value of the Stable-Growth Dividend Stage

The stable growth rate in this example starts in Year 11 and beyond. We use The Constant Growth Rate Model to calculate the value for this stage of growth, also called the â€śTerminal Value.â€ť The Terminal Value is the value of dividends from Year 11 (\$3.42) and beyond. We are assuming a stable growth rate of 4% (g = 4%) and a discount rate of 10% (r = 10%) in the example below.

Because the Terminal Value is at the end of Year 10, we discount it back 10 years to get the Stable-Growth Dividend Present Value in Year 0:

Terminal Value, Click on it to enlarge.

#### Step Three: Calculate the Intrinsic Value (IV)

The intrinsic value is the total of the Multi Phase Growth and Stable- Growth Present Values, or \$36 per share:

Intrinsic Value, Click on it to enlarge.

Since the stock price was \$35 when we did this analysis and the intrinsic value is \$36, the company is expected to return slightly over our requiredÂ 10% per year.

This is the same result as in the Brookfield Infrastructure post and illustrative of the essential steps for determining intrinsic value using the Dividend Discount Model.

From a practical standpoint using anÂ Excel spreadsheet will save you a lot of time and help reduce errors. The use of Excel facilitates doing sensitivity analysis or alternative cases, where we can examine the impact of different assumptions on the outcome.

#### Step Four: Sensitivity Analysis

Although sensitivity analysis is not a required step to value an investment, it is important and, I rarely do aÂ valuationÂ without some.

Remember Whitney Tilsonâ€™s advice; â€śGood thinking about valuation is less about plugging numbers into a spreadsheet than weighing many competing factors and determining probabilities. It’s neither art nor science — it’s roughly equal amounts of both.â€ť

The numbers in a spreadsheet provide the â€śscienceâ€ť or quantitative part. Our assumptions however, are the basis for these numbers and require â€śgood thinking,â€ť for the qualitative â€śart.â€ť

The sensitivity cases help us better understand the probable range of outcomes. Letâ€™s look at a sensitivity example.

Example of a Sensitivity Analysis

Brookfield Infrastructure has been exceeding their dividend growth range target of 5 – 9%. The most recent increase, for example, was 11%. If we think this strong growth may continue based on knowledge of the company, then perhaps our 7% growth above is too conservative.

Recent strong performance and near term significant growth, may indicate to some investors the high end of the dividend growth range may be a better assumption to use, at least for a while.

The case below shows, how changing the dividend growth rate assumption from 7% to 9% for the next five years impacts the intrinsic value.

DDM Sensitivity Example, Click on it to enlarge.

WithÂ a spreadsheet, we can readily change the growth rate to 9% for 5 years, to determine the intrinsic value of \$39 per share. With a stock price of \$35 at the time of this analysis, as expected the company’s return is more attractive.

#### Evaluating Investment Information

We all get â€śstock tipâ€ť right? Letâ€™s say you read or hear that this companyâ€™s intrinsic value is \$100 per share. Then howÂ do you evaluate the quality of this information? One way you can do this in our example, is increase the dividend growth rates. What level of growth would be required for a present value of \$100 per share?

AÂ present value of \$100 per share requiresÂ a dividend growth rate of about 21% per year. That is unlikely to happen and we can conclude that estimate is probably too optimistic.

Sensitivity analysis like this are useful in determining how the assumptions hold up to the â€śgood thinkingâ€ť test. They also help develop a possible range of outcomes andÂ for testing divergent points of view.

Brookfield Infrastructureâ€™s track record showsÂ a 7% or 9% dividend growth rate is certainly achievable. A 21% is not likely in my view.

#### Summary

The ability to estimate intrinsic value provides the reference point we need to make intelligent investment decisions. The Dividend Discount Model’s four essential steps summarizes aÂ tool we can use with dividend companies. It provides a way to freeÂ us from dependency on others on where we place our hard-earned money.

BroaderÂ valuation methods areÂ used on non-dividend stocks. We’ll examine them in the future. Let’sÂ put this first tool to good use until then to improve our investing. The best of investing to you!

Long BIP

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