This begins several videos on my favorite financial equation… the Dividend Pricing Model!! (also called the Dividend Discount Model or DDM)
VIDEO SUMMARY
This video is on the Dividend Pricing Model. This equation is my favorite financial equation. I am really excited to make this video. I am going to put up the equation. It seems like a simple equation but there is so much going on in it. Now before we get started, I want to recommend you go back and watch some of my previous videos, if you have not already done so. This is part of a video series on the core concepts of finance, and my earlier videos are really setting the foundation for this video. So if you have not already seen them, I highly recommend you go back and watch those earlier videos.
Let’s jump into the dividend pricing model. To understand this equation, you really need to understand some history. This was first published in a paper by Myron J. Gordon in 1956. He developed this equation trying to solve a very specific situation. So he came up with the Dividend Pricing Model as a way to determine the price for a series of dividend payments. Let me explain the situation he was evaluating. He was trying to find a way to easily and effectively value a certain type of financial opportunity. He was looking at big companies that pay large dividends. When you look at a very large company, let’s say a large capitalization US company, one of the main drivers of why it might be a good investment is they would pay a large dividend payment. They may not be growing as a company, but they are still successful. They are a reliable source of cash flow and so every year, this company generates a profit. It accumulates cash and eventually that cash will get paid out to the owners. The owners in a corporation are stockholders. So every year, this company is making dividend distributions of this excess cash. It is accumulating and the stockholders get a percentage of that dividend distribution based on the percentage of stock they hold. So when you are looking at an opportunity of purchasing the stock for a dividend paying company, how do you price that opportunity? How do you determine what an effective price you should be willing to pay for the opportunity to partake in dividend distributions out into the future? That is what this equation does.
It is based on the very fundamental economic idea that the price you would be willing to pay for something is the present value of the future benefits you are expecting to receive. In the case of dividend payments, you are going to expect to receive a set of dividend payments out into the future. If you forecast that out, you can take each one of those payments, and take the present value of that payment, of what that payment is worth to you today based on your assessment of the risk or uncertainty of that payment. You can add those payments together and that will give you the economic value for you today. That should be the price you are willing to pay for this opportunity. That is what this equation does. So what you can do with it is apply it to similar situations when you are making financial decisions. You can take a couple of similar companies that are going to all pay different dividends, you can figure out what that would be and then you can compare those financial opportunities and get a sense of what an effective price you should be willing to pay for each company. You can then compare what those companies are trading for in the market, and determine if these are smart financial decisions. It creates a very scientific, mathematical, and simple way to calculate that out to determine the best opportunity for you.
What has happened over time, is this very narrow definition of the Dividend Pricing Model, has expanded to cover all kinds of financial opportunities because it is based on this very fundamental economic principle, that the price you would be willing to pay for something is the present value of a series of future economic benefits. If you define all those assumptions, you can determine a price you are willing to pay based on your assumptions. So it is applied to all areas of finance today. When you start learning about how investment banks work, and how financial contracts are written, it is quite shocking how much this equation plays into everything in Finance. It is a very powerful equation to learn and to know how to use effectively. So I’m going to make a couple of videos on the dividend pricing model. In the next video we are going to walk through the equation in more detail, talk about the variables, and I am going to show you some cool things you can do with it.
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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.