The dividend discount model is a fundamental stock valuation method. It values stocks by taking into account the present value of future dividends and ignores any appreciation in a stock's price. The DDM is versatile and can be used whether dividend growth is constant or changing. The expected dividends from various future time periods are discounted using a predetermined discounting rate to get their current/present value. Once you have assembled inputs for the DDM, using this model is straightforward.
Determine trailing dividends (D0) from Yahoo! Finance, Google Finance, Mornginstar.com, or another finance website. D0 is a critical input for the DDM model because the dividends help determine what the next expected dividend will be once a growth rate is incorporated. The last year’s dividend payments are easy to determine since they have already been paid out and are public data. Alternatively, if a value for expected dividend (D1) has been declared by the company, it can be used instead of multiplying the current dividend by the growth rate.
Determine the growth rate (g) for dividends. Dividends may grow steadily or inconsistently over various periods of time. Estimates for future dividend increases can be made by projecting historical dividend growth rates or by following management discussions about the company’s dividend policy. A dividend growth rate can also be determined using the retention method, in which the return on equity is multiplied by the retention ratio (b) or the compounding method. Here the formula for g is: g = ROE x b. The retention ratio is the fraction of earnings that is not paid out as dividends, but is instead reinvested in the firm: b = (Earnings – dividends)/(Earnings).
Establish the required return (r) to be used. The concept of the time value of money indicates that the current value of a dollar differs over various time periods. The required return comes into place to compensate investors due to factors like risk and inflation that make their money -- in this case dividends -- worth less in the future than they would be if they were paid now. The required rate of return for investors is composed of a risk-free rate and a risk premium. The most common way to calculate a required return is to multiply a stock’s beta by the market risk premium (Rm) and then add the risk-free rate (Rf). The equation looks like this: r = beta*Rm + Rf. The market risk premium varies over time, but a typical value of 6 percent is often used. The yield of the U.S. 10-year Treasury bond is often used for Rf, and a stock’s beta can be found on Yahoo Finance, Google Finance, Morningstar.com, and other finance websites.
Determine the discounting model to use. Each stock has different features that determine which formula or model should be used. Where P0 is the present value of the stock, D0 is the current dividend, D1 is the expected dividend, r is the discounting and g is the growth rate, the following formulas may be used. Zero growth rate dividends: P0 = D0 / r Constant growth dividends: P0 = D0 (1+g) / (r-g) or P0 = D1 / (r+g) if you found projections for dividends to be paid in the current year (D1) instead of dividends paid in the prior year (D0) Non-constant growth dividends: Discount each future dividend payment to its present value by dividing its future value by (1+r)^t where t is the number of years in the future that will pass before receiving that payment.
Compare the DDM value to the market value of the stock. Once the intrinsic value of the stock has been determined using the DDM, it is important to compare it with the market value and the nominal value if available. Consider buying undervalued stocks and selling overvalued ones.
Items you will need
- Calculator or a spreadsheet program
- Nearly all stock investments are worth more than the estimates generated by the dividend discount model because they appreciate in price. Investors benefit from growing stock prices when they sell their shares at a higher price in the future.
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