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The Dividend Discount

Ralph Wanger
The classic way to value a company is the dividend discount model, or DDM. The first serious model was invented by John Burr Williams in 1938 in The Theory of Investment Value. He started from the premise that serious investing was done in the bond market. The value of a bond was determined by the present value of all the coupon interest that would be received over the life of the bond, plus the present value of the principal repayment at maturity. Doing the arithmetic in 1938 was somewhat laborious, but tables had been compiled, making it easy to look up the answer.

Williams argued that the value of a common stock was the present value of all the dividends that an investor would receive in the future. A stock does not have a maturity date, so one doesn’t have to worry about principal repayment. One does have to consider the difference in payout stream, because bonds pay a constant coupon for a known number of years, and common stocks pay a dividend stream that can go up or down in the next year. Furthermore, the length of that dividend stream is unlimited.

Winter Zombies
From today’s perspective, it is generally believed that company earnings, and therefore dividends, will be in a continuing uptrend reflecting the growth in the economy and most businesses. That would not have been obvious to an analyst in 1938. The economy of the United States and of the rest of the world evolved rapidly in the 40 years that Williams would have considered, but there was no great evidence of steady growth.

Ralph Wanger does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.