Dividend Discount Model Valuation

Kennon-Green & Co. Fiduciary Financial Advisor, Wealth Management, Global Value Investing

I’ve been writing quite a bit about dividends and dividend investing over at Investing for Beginners at About.com.  One of the things I wanted to explain, but I feel is still advanced for that particular readership base, is something known as the dividend discount model, or rather a back-of-the-envelope adaptation of it.  (Please note that if you are a new investor, you should be over there, reading the thousands of pages of content I’ve written for beginners.  This site is more for my personal essays on economics, tax policy, my life, and advanced investing.)

[mainbodyad]Today, General Electric announced it was raising its dividend and it provides the perfect illustration of how this works in the real world so I can’t let the opportunity pass before explaining to someone how it works, even though I touched on it in The Joy of Cash Dividends.

Understanding Dividend Yield Valuation Through a Look at General Electric

First, the background: General Electric, one of the biggest individual positions in the personal and business accounts of my family following its collapse down to $6 per share during the depths of the recession, announced today that it is increasing the per share dividend by an additional two cents per quarter to $0.14 per quarter, or $0.56 per year.

The dividend still isn’t fully restored to where it was before the crash at $1.40 per share but it has increased substantially from the $0.40 per share where it was when the company’s board of directors significantly reduced it to conserve cash, strengthen the balance sheet, and weather the storm.

The news caused the stock to rise 3.85% in today’s trading.  Some of the derivatives we hold on the stock were up more than 25% today.  I also have some call options, which are extremely risky and a total, complete gamble (note: they are not investments, they are pure roulette and are not appropriate in virtually all cases for regular investors), that I explained in my essay on rolling forward call options.

The Lessons We Can Learn from the Dividend Increase Today

There are several lessons we can learn from how the market reacted to the dividend increase:

  • As countless empirical data has shown, rises in the stock market happen in quick, short, unpredictable bursts.  You cannot time the stock market.  You can only look for value, buy what you think is attractive on a long-term basis, and acquire as much ownership as you can without risking your financial well-being so that if your thesis turns out to be incorrect or the market turns against you, you can recover without any major detriment to your long-term needs and desires.
  • Stocks, especially blue chip stocks, are often driven by dividend yield valuation.  This becomes increasingly applicable the higher the percentage of earnings distributed as cash dividends.

Many Investors Price Dividend Stocks Like Fixed Income Investments with a Higher Risk Profile

Dividend Yield as a Valuation Technique

One way to look at valuation of stocks and is to estimated a targeted dividend yield level, future dividend per share figure, and then capitalize the result to come up with an estimated value per share. Image © "Hemera Collection/Thinkstock"

What does that mean?  It means that investors are treating the blue chip dividend stock like a bond.  Yesterday, when General Electric was paying the equivalent of $0.48 per year in dividend income, the stock had a dividend yield of 2.8% because the shares traded at $17.13 each.  ($0.48 dividend yield divided by 2.8% = $17.13 per share)

When the dividend was raised to $0.56 per year today, the stock increased $0.66 per share to $17.79 because, if there were no increase in the stock price, the dividend yield would have jumped to 3.3%.  Instead, investors drove the stock price up so the new dividend yield is 3.14%, which is still higher than it was before the announcement.  Why would they do this?  Because with a higher dividend, investors could pay a higher price for the stock and still receive a good dividend yield.  (You already know this instinctively … you pay more for an apartment building generating $100,000 in rents than one earning $25,000 in rents.)

How the Dividend Yield Valuation Could Influence the Stock Price

What would happen if the stock market demanded the same dividend yield – 3.14% – and General Electric restored the dividend on its common stock to the full $1.40 over the next few years?  In this case, we would take $1.40 divided by 0.0314, which is $44.58.  That is, if the dividend were fully restored, and the market demanded the same dividend yield, the stock should trade at $44.58 per share.

The intelligent investor would have to ask himself or herself several questions, including:

  • Will General Electric ever be able to fully restore its dividend based upon its earnings and cash flow?
  • If it does restore the dividend, how long will it take?  The more time required, the lower our annual compounding rate.
  • Will the stock market be satisfied with a 3.14% dividend yield by the time the dividend is fully restored, if that does in fact happen?
  • What is the projection for interest rates over that time period?  This is a total gamble, not even the Federal Reserve knows what actions it will be taking a few years from now.

Interest Rates Matter to Dividend Yield … A Lot

Dividend Discount Model Valuation

The dividend yield valuation is a rough application of something known as the dividend discount model, which was covered in detail by John Burr Williams in his famous valuation treatise. Image © "Hemera Collection/Thinkstock"

The last two questions are closely related.  Why do interest rates matter?  Because right now, General Electric is attractive to some investors because they can only earn 0.1% in the bank but 3.14% by holding GE shares.  The dividend, in their case, compensates them for the risk of day-to-day stock price fluctuations.  These are often well-to-do investors that have no need for the money in their account and thus have very little risk of being required to sell off their holdings in an emergency.

If inflation kicks up and short-term Treasury notes are yielding 5%, investors aren’t going to be willing to accept a 3% dividend yield from General Electric.  More likely, they would demand a 7% or 10% yield.  That means if the stock were paying a fully restored dividend of $1.40 per share, and the market demanded a 10% return on blue chip stocks relative to dividend yield, the shares would actually fall to $14 each ($1.40 dividend divided by 0.10 required dividend yield = $14.00 per share).

This seems counterintuitive but it is true.  It is possible that a few years from now, General Electric could have fully restored its dividend and be paying $1.40 per share in cash dividends instead of $0.56 per year, but have actually fallen in stock price due to changes in the opportunity cost relative to Treasury bills, bonds and notes!  In such a world, this would result from investors demanding more return to compensate them for leaving the relative safety of government bonds.

The Importance of Thinking for Yourself

Now, in my case, I have some defenses against such an outcome.  As I explained, I engaged in a form of asset / liability matching, just like an insurance company, when I bought my first house.  In essence, I took out a 30-year fixed-rate mortgage at 5%, effectively shorting United States currency.  If the Treasury bond yields were to increase, and drive down stock prices substantially, I would effectively see the value of my primary residence rise in nominal terms (not real terms), while the fixed-rate debt remained the same.  In essence, equity would be transferred to my balance sheet as a result of inflation, letting me pay off debt with dollars that were less valuable.  This should, at least in a small way, compensate me for the temporary fluctuations in the businesses and equity portfolios.  But that is far beyond the scope of this particular lesson and most people should pay off their mortgage and other debts, if possible, so they have few liabilities.

[mainbodyad]But the point remains … General Electric could fall to $14 per share or lower, or rise to nearly $50 per share, depending upon what happens to the dividend rate, interest rates on government bonds, and the shift in the stock market’s expectation for dividend yields.

That is where the art of investing comes in … I have my own personal hypothesis as to what wil happen to the company’s balance sheet and income statement over the coming years, as well as a general idea of what I expect to happen with the inflation rate.  I could be completely wrong.  But even if I am, I’ve positioned myself, and my businesses, so that the damage would be minimal and the upside could be huge.

The calculus may be completely different for you.  Inexperienced investors often do better by focusing on a conservative asset allocation model made up of low-cost, broadly diversified index funds coupled with dividend reinvestment and dollar cost averaging, and/or working with a respected, qualified, professional money management firm that can take into account the unique needs and risk profile inherent to the individual.