Total Payout Model: How It Updates the Dividend-Discount Model

Imagine you’re trying to figure out the fair price of a share of stock, like a piece of ownership in a company. One of the classic ways to do this is with something called the Dividend-Discount Model, often shortened to DDM. Think of it like this: if you own a fruit tree, you value it based on the fruit it’s going to give you year after year. Similarly, with stocks, the DDM says the value of a stock comes from the dividends, those cash payments companies sometimes give back to their shareholders.

The core idea of the Dividend-Discount Model is pretty straightforward. It argues that the present value of all future dividends a company is expected to pay is the true worth of its stock today. It’s like saying, “If I know how much fruit this tree will give me each year, and I know what fruit is worth, I can figure out what the whole tree should cost me now.” The model uses a discount rate, which is essentially your required return on investment, to bring those future dividends back to today’s dollars. The higher the risk of the company or the higher your desired return, the higher the discount rate you’d use, and the lower the present value of those future dividends would be.

However, the business world, and especially how companies return value to their shareholders, has evolved. While dividends are still important, many companies, particularly in sectors like technology, have embraced another powerful tool for returning cash to investors: share repurchases, also known as buybacks. Think of share repurchases like this: instead of just giving you fruit directly, the fruit tree company decides to buy back some of the ownership stakes in the tree itself. By reducing the number of outstanding shares, each remaining share becomes more valuable, and the ownership of the company is concentrated among fewer people. This is a way for companies to return cash that doesn’t involve directly paying dividends, and it has become increasingly popular.

This is where the Total Payout Model comes in. It’s essentially an update or a modification to the traditional Dividend-Discount Model to account for these share repurchases. The Total Payout Model recognizes that companies can return cash to shareholders in two primary ways: through dividends and through share repurchases. Therefore, to get a more complete picture of the value being returned to shareholders, we need to consider both.

Instead of just focusing on the present value of future dividends, the Total Payout Model looks at the present value of the total payouts, which include both dividends and share repurchases. It’s like expanding our fruit tree analogy. Now, we’re not just valuing the tree based on the fruit it gives directly, but also considering the value increase we get when the fruit tree company buys back some ownership stakes, making our remaining stake more valuable.

In practice, to use the Total Payout Model, you would forecast not only future dividends but also future share repurchases. This can be more challenging than just forecasting dividends, as repurchase amounts can be more variable and depend on factors like management’s view of the stock price and available cash. However, by including share repurchases, the Total Payout Model often provides a more accurate valuation, especially for companies that heavily utilize buybacks instead of, or in addition to, dividends. It gives a more complete picture of the cash flow shareholders are actually receiving or expected to receive from their investment.

So, the key modification is simple yet significant. The Total Payout Model expands the scope of the Dividend-Discount Model beyond just dividends to encompass all forms of cash returned to shareholders, most notably share repurchases. This makes it a more relevant and robust valuation tool in today’s investment landscape where share buybacks are a significant component of shareholder returns for many companies. It’s about looking at the entire pie of shareholder payouts, not just one slice.