Walk me through a Dividend Discount Model
Answer
This is mechanically the same as a DCF, but we’re solving for dividends instead of Free Cash Flows. See below for the steps:
Project out earnings down to EPS
Use historical dividend payout ratios to determine a go-forward dividend payout ratio
Use this to forecast dividends over the next 5-10 years
Discount each dividend to present value using Cost of Equity. Remember, banks use debt differently than other companies so we wouldn’t use the WACC
Calculate terminal value based on Price / Earnings multiple on the final year’s EPS
Discount terminal value using Cost of Equity
Sum the PV of the terminal value and forecasted dividends to get the company’s net present per-share value
Why this matters to bankers
Bankers sometimes need to use Dividend Discount Models for companies like banks, where working capital plays a fundamentally different role than the typical company.