Explaining the Dividend Discount Model

The equity discount rate is the difference between the expected rate of return on the overall market (usually the S&P 500 is used for the market return) and the risk-free rate, multiplied by the stock's beta. This figure is added to the risk-free rate to arrive at the equity discount rate.

OK, if you've gotten this far without falling asleep, I congratulate you. Let's say we have a company that will pay a dividend next year and then increase its dividend at a constant rate forever. Also, using the equation above, we've determined the equity discount rate for this company.

Drum roll, please. I now present to you the constant growth dividend discount model:

For the purposes of this column, I've made some oversimplifying assumptions, which are probably unrealistic in the real world. For many companies, the assumption of constant dividend growth just isn't appropriate because some companies have an increasing level of growth in their dividend rate for a number of years, after which the growth becomes constant. Other companies have one constant growth rate in the near term, followed by a different constant growth rate later. Still other companies have nothing constant at all with their growth rates, as their dividends are highly variable.

In these cases, consider two types of cash flows: the dividends received each year, and the price at which you sell the stock after some finite time horizon. The dividends each year must be estimated or the growth rates must be projected. Alternatively, the earnings and payout ratios can be estimated. The expected price of the stock at the end of the holding period -- the price you sell the stock for -- is itself determined by the discounted stream of dividend payments. These cash flows are then discounted back using the equity discount rate.

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At time of publication, Norton's fund was long Dynegy, though positions may change at any time.

Charles L. Norton, CFA, is a principal of GNI Capital, Inc., a registered investment adviser that manages a hedge fund, GNI Partners, L.P., as well as discretionary private client accounts. Norton had been a vice president in the equity research department of a New York-based hedge fund, where he was also a registered representative managing discretionary private client accounts. Prior to his experience on the buy side, Norton worked in the investment banking division of Salomon Smith Barney, where he was an analyst in the health care group, reporting directly to the head of the group. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Norton cannot provide investment advice or recommendations, he welcomes your feedback.