H-Model (Dividend Discounting Method)
The H-Model is an advanced method of dividend discounting that traders and investors use to value stocks.
Unlike more rudimentary models, the H-Model accounts for a gradual change in dividend growth rate, making it more realistic and relevant in many cases.
Key Takeaways – H-Model
- The H-Model is an advanced dividend discounting method used to value stocks.
- It accounts for a gradual change in dividend growth rate, making it more realistic and relevant in many cases.
- The H-Model operates in two phases:
- Phase 1 involves incremental changes in dividend growth rate over a specified period.
- Phase 2 assumes a stable dividend growth rate into perpetuity, similar to the Gordon Growth Model.
- The H-Model differs from the two-stage model by accounting for a gradual shift in dividend growth rate, providing a more nuanced approach to evaluating a company’s value based on its dividends.
The Two Phases of the H-Model
The H-Model operates in two distinct phases.
The first phase involves a gradual adjustment in the dividend growth rate over a specified period.
The second phase, akin to the two-stage model or the Gordon Growth Model, assumes a stable dividend growth rate into perpetuity.
Phase 1: Incremental Changes
During the first phase of the H-Model calculation, dividends are assumed to change incrementally each year.
For instance, a company’s dividend growth rate might decrease by 2% each year over three years, transitioning from 15% to 9%.
Phase 2: Stable Growth Rate
The second phase of the H-Model mirrors the Gordon Growth Model.
Here, the dividend growth rate stabilizes and continues at that rate indefinitely.
In the given example, the growth rate reduces to 7% in the fourth year and stays at that level.
H-Model vs. Two-Stage Model
In the two-stage dividend discount model, dividends grow at one rate and then abruptly drop to a lower rate for the foreseeable future.
This sudden change is a key distinction between the two models.
By accounting for a gradual shift in the dividend growth rate, the H-Model presents a more nuanced approach to evaluating a company’s value based on its dividends.
H-Model Calculation Example
Here’s the formula and the example values to value the equity of Company X:
Value of X (H Model) = D0 * (1+gL) / (r-gL) + D0 * H * (gS-gL) / (r-gL)
- D0 = $25 (dividend received in the present year)
- R = 8% (rate of return expected by the investor)
- gL = 5% (long term growth rate)
- gS = 12% (short term growth rate)
- H = 2.5 years (half-life of the high growth period)
We first need to convert the percentages to decimals:
- R = 0.08
- gL = 0.05
- gS = 0.12
Then, we can substitute these values into the formula:
Value of X (H Model) = 25 * (1 + 0.05) / (0.08 – 0.05) + 25 * 2.5 * (0.12 – 0.05) / (0.08 – 0.05)
Solving this step by step:
= 25 * 1.05 / 0.03 + 25 * 2.5 * 0.07 / 0.03
= 25 * 35 + 50 * 2.333 = 875 + 145.833 = $1020.33
Therefore, based on the given information and using the H model, the value of a share would be approximately $1020.33.
Criticisms and Limitations
Here are some key limitations of the H-Model (dividend discounting) for stock valuation:
- Assumes dividends will grow at a constant rate forever. In reality, dividend growth rates can fluctuate over time as a company’s profitability changes.
- Sensitive to the discount rate/required rate of return used. Small changes in the discount rate can significantly impact the valuation.
- Doesn’t account for future share repurchases, which can provide value to shareholders similar to dividends.
- Doesn’t consider capital gains from stock price appreciation. Only considers value from future dividends.
- Difficult to accurately estimate the appropriate dividend growth rate and discount rate to use. Requires a lot of assumptions.
- Works better for mature, stable companies with established dividend payouts vs high-growth companies with more variability.
- Ignores other qualitative factors that can influence stock value, like market position, management, intangible assets.
- Assumes the company will never stop paying dividends. Fails to account for dividend cuts or eliminations.
- Provides little insight into the timing of cash flows. Total PV of future dividends doesn’t indicate when they’ll be received.
Equity Valuation: Discounted Dividend Valuation (H-Model)
FAQs – H-Model
What is the H-Model?
The H-Model is a form of the dividend discount model that is used to calculate the intrinsic value of a stock by taking into account the present value of future dividends.
What makes the H-Model unique is that it assumes a gradual transition in dividend growth rates, rather than an abrupt shift from a high to a lower growth rate.
How does the H-Model differ from the two-stage dividend discount model?
While the H-Model and the two-stage dividend discount model both calculate the present value of dividends in two key phases, the way they handle changes in dividend growth rates is different.
The two-stage model assumes that dividends will grow at one rate, then suddenly drop to a lower, constant rate for the foreseeable future.
The H-Model, on the other hand, accounts for a gradual change in dividend rates over time, with the dividend growth rate assumed to change at regular increments each year.
What is the importance of the H-Model in finance?
The H-Model provides a more realistic approach to valuing a company’s stock by taking into account that dividend growth rates don’t typically change suddenly and dramatically, but rather transition more gradually.
This allows investors and analysts to get a more accurate understanding of a company’s intrinsic value and future prospects.
What are the stages in the H-Model?
The H-Model consists of two stages.
The first phase is where dividends are assumed to increase or decrease in regular increments each year, reflecting a gradual transition in the dividend growth rate.
Companies generally tend to mature and grow more slowly over time.
The second stage of the H-Model is identical to that of the Gordon Growth Model, where the dividend growth rate stabilizes and is maintained over the life of the company.
What are the limitations of the H-Model?
While the H-Model provides a more detailed analysis of a company’s dividend growth rate, it still has limitations.
The model assumes a linear change in growth rates, which may not always be accurate.
It’s also based on numerous assumptions about future growth rates and the time period of growth, which can be difficult to accurately predict.
Additionally, like other dividend discount models, it’s not suitable for companies that do not pay dividends.
The H-Model presents a more comprehensive and realistic method for the valuation of stocks based on dividends.
However, as with any financial model, it requires accurate input parameters and careful interpretation of the results.
Despite its limitations, its use can provide a more accurate picture of a company’s worth, especially when dividend growth rates are expected to change gradually over time.