Dividends are the best friend an investor has. They are the gift that keeps on giving and finding a company that pays them consistently over an extended period of time is a great way to build your wealth. Determining the intrinsic value of a dividend paying company is paramount to investing with a margin of safety. This helps protect our investments and grow our wealth. Using the dividend discount model is an excellent way to find that intrinsic value, and the use of the dividend discount two-stage model is a fantastic way to get a more precise view of that value.

Our goal is to find the approximate value of a company, not to quibble about the minor details; we must remember that valuation is an art. What one investor sees as value, another might see as a liability; it can be seen as in the eye of the beholder. 

The dividend discount two-stage model is a little more involved than the Gordon Growth model that we addressed last week, but it is doable on our part. We will walk through all the steps to help you calculate it on your own and give you examples to help illustrate what we are doing.

What’s the big deal with dividends, and why do we keep talking about them?

To give you an example of the power of dividends, let’s take a look at our favorite guru, Warren Buffett. Over the years Buffett has grown his wealth by investing in and buying businesses with strong competitive advantage (moat) that have traded at fair or better prices.)

His favorite company to invest in is one that pays him a dividend. Did you know that?

This has helped lead to incredible wealth for him; he has used the compounding nature of stocks and their dividends to accumulate much of his wealth.

Consider this, his top 4 holdings which include Wells Fargo (WFC), Coke (KO), Kraft Heinz (KHC), and IBM all pay handsome dividends, equating to a yield of 2.9% and consider that Coke has paid a growing dividend for 55 years!

Another fact to consider is the over the last ten years the Dividend Aristocrats have outperformed the market, the S&P 500 by almost 2.64%. This makes dividends and incredibly powerful force to be reckoned with and why we focus a lot of our attention on them.

Dividends plus compounding over time equates to a powerful force that is hard to beat.

Because dividends are such a big deal we need a way to value these companies, and that answer is the Dividend Discount Model.

Dividend Discount Two-Stage Model

What is this model and how is it different from the Gordon Growth model I already know?

The Gordon Growth model is a simple, but powerful way to value dividend paying stocks, but it has one pretty big flaw, it takes it on faith that the growth rate for the company that you are valuing is going to continue growing at that same static growth rate forever.

And you and I know that this is simply not possible, the vagaries of the stock market and business lead to an incredible amount of volatility and cycles that all companies go through.

And so enter the two-stage model of the Dividend Discount Model. It allows you to enter different growth rates as the company evolves and enables you to get a greater range of outcomes, which helps us in our valuations.

The remarkable part of this model is the ability to adjust the growth rates for some years, in essence giving you control of how you value that particular company. As the company goes through its growth spurt, no pun intended, you can adjust for a slower growth rate and a declining growth rate, if you wish.

Dividend Discount Two-Stage Model: Formula & Examples

Okay, on to the formula.

Intrinsic Value  =  DPS / ( 1 + Khg) + P / (1 + Kst)

Where P = DPS / kst – g

So what does all that mean? Don’t worry; I will lay it all out for you.       

First, the variables are as follows:

DPS = Expected dividends per share in year

Khg = Cost of equity during high growth rate

Kst = Cost of equity during stable growth rate

G = Extraordinary growth rate for the first number of years