DDM to Estimate Market Return and Risk Premium

Imagine you are thinking about investing in the stock market as a whole. It can feel a bit daunting, like trying to predict the future. But what if there was a way to estimate what kind of return you might reasonably expect from the overall market? That is where the Dividend Discount Model, or DDM, comes in.

Think of it this way: when you invest in a company’s stock, you are essentially buying a piece of ownership in that company. And what do companies often do with their profits? They distribute some of it back to shareholders as dividends. The Dividend Discount Model is built on the idea that the value of a stock, and by extension, the value of the entire market, is based on the present value of all the future dividends investors expect to receive.

Now, let’s scale this up to the entire market. Instead of looking at one company’s dividends, we consider the aggregate dividends paid out by all the companies in a market index like the S&P 500. We can think of the entire stock market as one giant company that pays out a collective dividend.

To apply the DDM to the market, we need a few key pieces of information. First, we need the current dividend yield of the market. This is essentially the total dividends paid out by all companies in the index over the past year, divided by the current value of the index. You can often find this information readily available from financial data providers.

Next, we need to estimate the expected growth rate of these market dividends. This is where it gets a bit more forward-looking. We are trying to predict how much we expect total market dividends to grow each year in the future. A reasonable starting point for this growth rate is often the expected long-term growth rate of the economy, or perhaps the expected growth rate of corporate earnings, as dividends tend to follow earnings over time. Let’s say, for example, we expect the market dividends to grow at a rate of 5 percent per year.

Once we have the current dividend yield and the expected dividend growth rate, we can use a simplified version of the DDM to estimate the expected return on the market. This simplified model, often called the Gordon Growth Model when applied to individual stocks, works well for the market as a whole under certain assumptions.

In this simplified market DDM, the expected market return is calculated by adding the current dividend yield to the expected dividend growth rate. So, if the current market dividend yield is 2 percent, and we expect dividends to grow at 5 percent per year, then our estimated expected market return would be 2 percent plus 5 percent, which equals 7 percent.

This 7 percent represents the total return investors can expect to receive from the market, based on dividend income and dividend growth. It’s important to remember this is an expected return, not a guaranteed return. The actual market return in any given year could be higher or lower.

Now, let’s talk about the market risk premium. The market risk premium is the extra return investors expect to receive for investing in the stock market, which is considered riskier than a ‘risk-free’ investment like government bonds. Think of it as the compensation investors demand for taking on the uncertainty and volatility associated with the stock market.

To estimate the market risk premium using the DDM approach, we first calculate the expected market return, as we just did. Then, we need to determine the risk-free rate. A common proxy for the risk-free rate is the yield on long-term government bonds, like 10-year Treasury bonds. Let’s say the yield on 10-year Treasury bonds is currently 3 percent.

The market risk premium is then simply the difference between the expected market return and the risk-free rate. In our example, with an expected market return of 7 percent and a risk-free rate of 3 percent, the market risk premium would be 7 percent minus 3 percent, which equals 4 percent.

So, using the Dividend Discount Model, we have estimated that investors should expect a return of 7 percent from the overall stock market, and that the market risk premium, the extra return for taking on market risk, is around 4 percent.

The DDM provides a useful framework for thinking about expected market returns and the market risk premium. It is based on the fundamental principle of valuing assets based on their future cash flows, in this case, dividends. While it relies on estimates and assumptions, particularly about future dividend growth, it offers a grounded and intuitive approach to understanding what drives market returns and risk premiums. It’s a valuable tool in the investor’s toolkit for making informed decisions about the market as a whole.