What is the Dividend Discount Model?
The Dividend Discount Model (DDM) is one of the most common methods for evaluating stocks. The DDM uses dividends and expected growth in dividends to determine the correct value of a stock based on the required rate of return you seek. It is particularly effective for valuing large, reputable stocks.
What is the DDM?
There are many versions of the DDM, but two of the basic versions described here include determining the required rate of return and determining the correct stock value.
Stock Value = Dividends per Share / (Required Rate of Return – Dividend Growth Rate)
Rate of Return = (Dividends Paid / Stock Price) + Dividend Growth Rate
Determining the Required Rate of Return
You may have an idea of what kind of return you want to see from the stock, but it’s helpful to first understand what the actual rate of return is based on the current stock price. This is determined by the following formula:
Rate of Return = (Dividends Paid / Stock Price) + Dividend Growth Rate
Determining the Correct Stock Value
If your goal is to determine whether the stock is fairly priced, you should reverse the formula.
The formula for determining the stock price is:
Stock Value = Dividends per Share / (Required Rate of Return – Dividend Growth Rate)
Limitations of the DDM
The Dividend Discount Model is not suitable for some companies. For instance, it is impossible to use it for any company that does not pay dividends, making it unsuitable for valuing growth stocks in this way. Additionally, the model is difficult to use for new companies that have just begun paying dividends or those with irregular dividend distributions.
One of the drawbacks of the Dividend Discount Model is that it can be very sensitive to small changes in dividends or growth rates. For example, in the case of Coca-Cola, if the dividend growth rate is reduced from 5% to 4%, the stock price would drop to $42.60. This represents a decline of more than 5% in the stock price based on a small adjustment in the expected growth rate of dividends.
Frequently Asked Questions (FAQs)
Why does a stock’s value depend on dividends?
Dividends are a financial payment. They have a value that should be factored into the stock price – just like any other asset that gives the company value. If there are two identical companies, except one is paying dividends, it is expected that the stock price of the dividend-paying company would be higher. Not all stocks pay dividends, so dividend payments alone do not determine a stock’s value.
What gives stocks their other value?
The value of a stock depends on many things, including major factors such as the company’s financial performance and industry outlook. Investors use metrics like the price-to-earnings ratio, earnings per share, and profit margins to better evaluate that value. Ultimately, a stock’s value is based on your own investment goals and opinions. If you are willing to buy or sell a stock at a certain price, then that price is the stock’s value to you.
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Source: https://www.thebalancemoney.com/how-to-use-the-dividend-discount-model-to-value-a-stock-4172616
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