The Triple Margin Of Safety With The Dividend Discount Model

I’ve received a few questions lately regarding my usage of the dividend discount model analysis when I analyze and value high-quality dividend growth stocks.

What is the dividend discount model? How does it work? 

It’s not lost on me that I’ve never written an article specifically devoted to the DDM. I long ago decided to avoid writing technical/instructional articles (what a dividend is, what a payout ratio is, etc.), as I don’t want to become a dictionary for people. I started to write articles like these when I first started, but I quickly realized what a slippery slope it is.

I can’t be all things to all people, so I’ve always focused on writing content for people who are already more or less hitting the ground running with some basic knowledge already accumulated. In addition, I’ve compiled excellent resources to get the ball rolling for beginners.

There are thousands of articles describing the mechanics of the dividend discount model and how to go about applying it, like Investopedia’s piece. I’m not sure I can really add any more value to the subject. And there are also a number of calculators out there that make the DDM a cinch. One of my favorite calculators is incredibly flexible, allowing one to apply a one-stage or two-stage model, and the output of that calculator will be the same as what I come up with in my articles. (One just has to substitute dividends for earnings, although there are hundreds of other DDM calculators available online.)

But I’m a big fan of the DDM. And I’ve used it extensively whenever it came time to estimate the intrinsic value of any stock I was interested in adding to my Full-Time Fund.

As such, I want to take the time today to discuss the dividend discount model analysis from a high level and how I believe it has three margins of safety built right into the model, when used appropriately.

The Discount Rate

The discount rate is the first margin of safety.

If you follow my writing, you’ll notice that I almost always use a 10% discount rate when I value dividend growth stocks.

There’s a reason for this.

First, let’s back up for a second.

The discount rate is basically the long-term rate of return you’re modeling in when you use the DDM. So if you model in a 10% discount rate, you’re basically saying that you’re accepting no less than an annualized 10% long-term total return. The lower the discount rate, the higher the intrinsic value will be in the DDM’s output. The higher the discount rate, the lower the valuation output will be (assuming all other input is equal).

So I use a 10% discount rate because it’s a reasonable expectation for most high-quality dividend growth stocks. It’s also a very satisfactory annualized rate of return when I consider the involved risks and the time value of my money.

But there’s also a margin of safety built right into that.

See, the long-term nominal compounded annualized rate of return for the broader market (including dividends) is somewhere around 9%, with the real rate being between 6% and 7%.

So by using 10%, I’m modeling in an annualized long-term compounded rate of return that exceeds what the broader market has done over the last 100+ years.

Although I don’t use the S&P 500/broader market as a benchmark for any type of comparison to my own performance, I have to start somewhere. Moreover, as noted above, I consider 10% very satisfactory relative to my own views on risk and the time value of my money.

I will occasionally use a lower discount rate when stocks offer yields above 4%, as the time value of money tells me that money in my hand today is worth more than money in my hand tomorrow. As such, high-yielding stocks are, all else equal, worth more to me than low-yielding stocks.

Nonetheless, the margin of safety appears to be built in here. The higher the discount rate, the greater the margin of safety. However, if the discount rate is too high, you’ll likely find it very difficult to find any investment candidates.

But if you’re using a discount rate that is appropriate, you should be building in a margin of safety that then also means the output (the estimated fair value of a stock) is conservative.

The Dividend Growth Rate

The dividend growth rate is the second margin of safety built right into the DDM.

But it’s only a margin of safety if you model in a dividend growth rate that’s conservative.

I generally consider a conservative dividend growth rate to be one that is markedly lower than the demonstrated long-term dividend growth rate of a company.

In addition, I also consider long-term EPS growth and expectations for a company’s underlying growth moving forward.

Finally, a payout ratio must also be considered. The lower the payout ratio, the more room a company has for a high dividend growth rate. In fact, dividend growth could outstrip underlying EPS growth for a long period of time when a payout ratio is well below 50%.

A good example of a conservative dividend growth rate is the rate I used in my DDM analysis when I recently valued Enbridge Inc. (ENB).

The 10-year dividend growth rate for ENB is 12%. The company is guiding for 10-12% dividend growth through 2024. S&P Capital IQ believes Enbridge will compound its EPS at an annual rate of 10% over the next three years. And Enbridge is paying out less less than 60% of its available cash flow from operations.

So you have a demonstrated double-digit dividend growth rate over a fairly long period of time. You have a company that’s guiding for that to continue for the foreseeable future. An outside firm backs that expectation up. Meanwhile, you have a payout ratio that is modestly elevated (though very reasonable for this industry).

So what did I model in?

Well, I modeled in a 6% long-term dividend growth rate.

I don’t see how one could argue this is anything but extremely conservative.

However, every business is different. And I view pipeline/energy infrastructure companies to have a bit more risk than your average company due to the very business model. And so I want to be conservative.

But this is another margin of safety that one has at their disposal when using the DDM.

If you’re conservative with the long-term dividend growth rate, you should be building in a second margin of safety, which then naturally means the output (the estimated fair value of a stock) is also conservative.

The Price Paid Relative To The Output Of The DDM

The price you pay for a stock is the third margin of safety that one has at their disposal when using the DDM.

As I’ve shown, the estimated fair value (the output of the DDM) should be quite conservative, as two margins of safety (via the discount rate and long-term dividend growth rate) are built right into the number.

So, for example, if you get a fair value of $50 for a stock after being conservative with the discount rate and long-term dividend growth rate, you should have a conservative idea as to what the stock is intrinsically worth.

But the margin of safety certainly doesn’t end there. 

Paying much less than $50, in this example, is then the final hurdle to clear when thinking about three margins of safety.

I usually aim to pay at least 10% less than the final output of any DDM analysis.

In this example, I’d aim to pay $45 or less for this stock. The lower the price paid, the better.

Conclusion

I would say that the most common margin of safety discussed in the investment world is the price paid relative to the estimated intrinsic fair value of a stock.

So if you believe a stock is worth $50 but you pay $40, you have a very solid margin of safety built in to the investment.

However, I think one’s margin of safety should and can go much deeper than that.

If you use a DDM appropriately, you should be factoring in a conservative discount rate and long-term dividend growth rate (either via a one-stage or two-stage model) with every stock you quantitatively analyze. When that’s done, you have a margin of safety built in three times over. And when you have three hurdles cleared like that, it makes it pretty tough to significantly overpay for a stock.

Essentially, a triple margin of safety means the price paid for a dividend growth stock will be far below the estimated fair value of said stock that in and of itself is conservative twice over.

Even if a company doesn’t grow its dividend as fast as you modeled in (even if your model was conservative), you should still have two more margins of safety built in. So even if they grow much slower than anticipated, that means your total return might drop a bit, perhaps back down to what the broader market has done over the long haul. This is not really a terrible outcome. Moreover, you should have paid much less than the final output, protecting you against long-term downside in case something really goes wrong.

The DDM isn’t perfect. No valuation model is. But it’s essentially a tailored version (for dividend growth stocks) of the discounted cash flow model, which is more or less the “gold standard” for valuing stocks. One could do much worse. And if used correctly, you should have very low odds of overpaying for any high-quality dividend growth stocks. In fact, I find the odds to be pretty great that one is going to get a very good price on almost every stock they buy if/when they use the DDM correctly and build in that triple margin of safety.

Full Disclosure: I’m long ENB.

What do you think? Do you use the DDM? Do you see how a triple margin of safety can be built right into the DDM?

Thanks for reading.

Image courtesy of: Sira Anamwong at FreeDigitalPhotos.net.