The Dividend Discount

The classic way to value a company is the dividenddiscount model, or DDM. The first seriousmodel was invented by John Burr Williams in 1938in

The Theory of Investment Value

. He startedfrom the premise that serious investing was donein the bond market. The value of a bondwas determined by the present value of all thecoupon interest that would be receivedover the life of the bond, plus the present value ofthe principal repayment at maturity. Doingthe arithmetic in 1938 was somewhat laborious,but tables had been compiled, making it easyto look up the answer.

Williams argued that the value of a commonstock was the present value of all the dividendsthat an investor would receive in the future.A stock does not have a maturity date, so onedoesn’t have to worry about principal repayment.One does have to consider the difference in payoutstream, because bonds pay a constant couponfor a known number of years, and commonstocks pay a dividend stream that can go upor down in the next year. Furthermore, the lengthof that dividend stream is unlimited.

Winter Zombies From today's perspective, it is generally believedthat company earnings, and therefore dividends,will be in a continuing uptrend reflectingthe growth in the economy and most businesses.That would not have been obvious to ananalyst in 1938. The economy of the United Statesand of the rest of the world evolved rapidlyin the 40 years that Williams would haveconsidered, but there was no great evidenceof steady growth.

An analyst would have remembered the catastrophesof the Great War and the Depression of1921, then the euphoria of the late 1920s, followedby the Depression, when the ghosts of bankruptcyand Bolshevism caused the same fear of thefuture as when the White Walker zombie armycrashed through the Wall into a helpless Westerosin Game of Thrones. The Dow Jones IndustrialAverage was 100 in 1905 and 100 in 1942. So, theidea of a buy-and-hold strategy would haveseemed preposterous to the handful of investorswho had not already been turned to zombiesin the dreaded winter of 1932.

There are several practical problems with theWilliams dividend discount model. First,the present value of an income stream extendedfar into the future is so hard to estimatecorrectly that the present value calculation isnearly meaningless. The math tends tobe dominated by events more than 10 yearsin the future about which you and I knownothing. If you think otherwise, find a collectionof the analyst reports that you and yourcolleagues wrote 10 years ago.

Another blow to the DDM is the disappearanceof dividends, leaving nothing to discount or model.In the early 1990s, corporate managementsmade the agreeable discovery that the success oftheir company was primarily due to the managerialgenius of themselves. Therefore, becausethe increase in stock prices was created by thesemanagers, they were clearly undercompensatedfor the riches they were bestowing upontheir indolent shareholders.

The invention of stock options righted this wrong.It allowed the management group to seize 4%of the company every year, under the threat thatless compensation would cause them to transfertheir wealth-making power to a competitor.In this model, dividends were a nuisance becausethey were not factored into the option calculation.Dividends were cut or eliminated, and themoney that would have gone to shareholders wasput into stock-repurchase programs. A largestock-repurchase program would offset the stockdilution caused by the stock-option program.That way, at the end of the year, the companywould have the same number of sharesoutstanding but with the managers owning moreand the shareholders owning less. This transferof wealth from owners to managers hasbeen remarkably easy. Shareholders never knewwhat hit them.

Sell Signals Despite the numerous shortcomings of thedividend discount model, it has been useful in thepast and should continue to have value in thefuture, probably by broadening the definition ofdividends to include stock repurchases.

I first used it as a theme of my senior thesis atMIT in 1955. I took the Williams model of 1938 andfiddled with it to account for senior securitieson the balance sheet and added a way to taperfuture growth to adjust for the inevitable meanreversion of a highly profitable company. There wasa new DDM in academia at that point, theGordon-Shapiro model, which led to the equationp=d/(r-g).1 I was able to show that this wasformally the same as the Williams DDM.

When I started running a mutual fund in 1970, Ithought that a DDM would be useful in comparingstocks in different industries, so I adopted amodel invented by U.S. Trust. At that time, U.S.Trust was a leading institutional manager using thesame “Nifty 50” strategy as every other bankin New York. By 1972, the model was throwing offsignals that stocks were wildly overpriced. Theterrible bear market of 1973–74 proved that theDDM had given a valid signal. Everybody saw theirportfolios drop 50%.

In 1974, I called one of my buddies at U.S. Trustto congratulate him on the success of thefirm’s model forecast. My friend was not in a goodmood. He told me that the bank, seeing that themodel was generating sell signals, did the sensiblething and scrapped the model. My buddy hadbeen fired and was just in his office to pack up thekids’ pictures and the golf trophy. (U.S. Trustwas acquired by Bank of America BAC in 2007.)

Future Value The world has changed a lot since the 1960s. Inthose days, most businesses were capitalintensive;to grow, they needed a high returnon equity. They could then pay out half the profitsin dividends and plow the other half intoexpanding their factory. The clearest exampleof this was the electric utility industry. The numberof kilowatt-hours used in the country grew at 7%per year from 1912 to 1972. Utility companies,therefore, had to continuously build newgenerating capacity. State regulators allowed theutilities a high rate of return on the new plant, sothat shareholders received a constantly increasingdividend stream. Because the technology ofgenerating electricity improved steadily, utilitieswere able to reduce the price of electricity toconsumers, delighting the public and theregulatory agencies. 'Twas a veritable paradiseon earth.

The DDM was ideally suited to value electricutility stocks, and I remember having earnestdiscussions as to whether the long-term growthof Commonwealth Edison would be 6% or6.5%. Then in 1973, OPEC found that it had thepower to quadruple the price of oil, and the priceof coal and electricity soared as well. With higherprices, the growth of utility usage went flat.Beginning in 1990, electricity growth droppedto zero. Utility companies went to their regulatorsto have prices adjusted upward and weresurprised to find that the same regulators who hadbeen so cooperative approving price decreaseswere no longer friendly at all. The DDM wasno longer useful in predicting utility stock prices.

So, the dividend discount model is not that useful,because the future is too uncertain. But we alreadyknow that. The DDM is still of value, solving for g,the growth rate implied by the stock price. If theimplied growth rate is suspiciously high, you mightdecide that you are assuming that a high returnon equity may be true now, but mean reversion willspoil your longer-term euphoria.

1 Gordon, M.J. 1959. “Dividends, Earnings, and Stock Prices,” The Review of Economics and Statistics, Vol. 41, No. 2, pp. 99–105. I did my work from Gordon’s work at MIT in 1955.

This article originally appeared in the December/January 2018 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.