Understanding the Dividend Discount Model?
Hi all,
Having some trouble wrapping my head around dividend discount model as a valuation approach, compared to a DCF.
I understand a DCF as a tool for arriving at an implied share price as saying: the present value of the future cash flows to equity for this company are $X. As the company has N shares outstanding, the implied value per share, and thus the max price I'm willing to pay, is $X/N.
What I don't understand about the DDM is, why are you using the projected dividend stream ($Y) as the only cash flow? This seems to be at odds with the logic of a DCF, that's saying as a shareholder, your value is $X/N, where as the DDM would be saying the only cash flow you have a claim on would be $Y, for a value per share of $Y/N, which would necessarily result in a lower value of the company.
Am I missing something? Don't these both say conflicting things about the cash flows your share in a company represents (is it a share of the company's levered cash flow or the actual dividends paid out?)
Thanks very much!
With DCF you calculate enterprise value from which you need to deduct net debt to arrive at equity value. With a DDM you calculate equity value.
In addition the discount rate is very different. In a DCF you use WACC while in DDM you wil use cost of equity.
Thanks, this makes sense. I think my question is more - are the cash flows you use for DDM total levered cash flow or projected dividend payments (do you assume the projected dividend payments equal total levered cash flow or that only some % of levered cash flow is paid out as a dividend?)
Dividends as the reinvested cash will drive the increase of profits in the future (capex in projects that generate a positive NPV), so taking the reinvested cash into account already is sort of double counting.
Got it - I'm just trying to understand why a DDM would give you pretty different value for a company than a DCF run off of levered free cash flows, where you're using the cost of equity as discount rate for both.
For example, if we assume maybe 20% of levered free cash flows are paid out as dividends, wouldn't the DDM arrive at a lower valuation because it's calculated off of 20% of the cash flows that would be used in a DCF run on levered cash flows? That doesn't make sense to me
DCF FCF includes capex, change in w/c etc. All those items are not reflected in net income
Makes sense, thanks very much!
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