Evaluating Stocks using Dividend Discount Model

Dividend discount model is a widely accepted financial tool used to evaluate stocks based on the net present value of the future dividends. It works by analyzing and making assumptions related to growth in dividends and interest rates. It’s a tool that is heavily based on speculation but what sets it apart from other financial tools is its ability to compare specific numbers based on the given data with accuracy.

Dividend discount model can only be applied to stocks that pay dividends. Dividends are portion of earnings that a company decides to give out as cash or stock to its shareholders. Companies that offer dividends, like Microsoft, are usually very stable and secure and have financial strength to continue paying dividends.

Dividend discount model can also help investors decide if the future growth in dividends is worth the investment today. The concept of time value of money is crucial in calculations related to dividend discount model. Future growth in dividend payments is discounted to present value of the stock to see if the stock is undervalued or overvalued. Basic dividend discount model formula states that: There are no two stocks alike so dividend discount model is available both for companies where growth is imminent and companies with no growth. No growth dividend discount model assumes that a company will pay the same amount of dividend until infinity. Constant growth dividend discount model assumes that the company will grow and so the dividends will also grow.

No growth dividend discount model dictates the formula: Where P is the current price, Div is the dividend the company currently pays and r is the discount rate. Formula for constant growth dividend discount model is: g is the growth rate which is assumed in most cases.

Let’s say that a company is paying \$.60 in dividends and the required rate of return in other securities is equal to 6%. Looking at other growth stocks, assume 2% growth rate. Using dividend discount model, we just figured out the current price of the stock which is \$15. Now let’s say that the stock is currently selling for \$12, which makes the stock undervalued. If the stock were to be \$18, we can assume that it is overvalued.

It’s a good idea to buy a stock that is undervalued because the amount of future cash flows it is able to generate. Using dividend discount model, it is very easy to identify growth or income stocks that can prove to be profitable if the investment is made in the present.

On the other hand, one has to keep in mind that dividend discount model is highly speculative and is based on variety of assumptions. In theory, it is one of the best financial tools available to investors but in the real world, it is better to use wide range of tools to evaluate stocks.

In future if I am trying to make a decision and evaluating stocks, I will definitely use dividend discount model to identify undervalued stocks. Risk in stock market will always be there but financial tools like dividend discount model help us make an intelligent decision based on the information provided to us.

1. joshua tembo October 25, 2008 at 2:56 pm

in the discount model formula, how is the r (required return) determined?

joshua

2. joshua tembo October 25, 2008 at 6:56 am

in the discount model formula, how is the r (required return) determined?

joshua

3. Zahid Lilani October 25, 2008 at 10:34 pm

It is a made up number, you make it up depending on how much return your heart desire from investing in a stock overtime.

4. Zahid Lilani - Site Author October 25, 2008 at 2:34 pm

It is a made up number, you make it up depending on how much return your heart desire from investing in a stock overtime.

5. Olga February 8, 2009 at 1:24 pm

Zahid, I suppose Joshua and the rest should also mind taking a glimpse at the CAPM and WACC models. And the arbitrage pricing model too. Just so that their hearts dont desire the r over 100% 🙂

6. Olga February 8, 2009 at 5:24 am

Zahid, I suppose Joshua and the rest should also mind taking a glimpse at the CAPM and WACC models. And the arbitrage pricing model too. Just so that their hearts dont desire the r over 100% 🙂

7. Rohit June 11, 2009 at 6:01 am

r is the cost of equity & hence should not be confused with the WACC which is the firms weighted average cost of capital (i.e. including cost of debt). Unless a firm is 100% equity financed, the WACC will not be the same as cost of equity!

the formula for r is (dividend/share price) +growth rate %

The cost of equity will always be higher than debt as debt will carry a tax shield. CAPM will be useful too but again the model suffers from the same limitations as the DVM due to the assumptions such as market rate, risk free rate and beta values. Also not useful for layman as can be complex

8. Rohit June 11, 2009 at 6:32 am

The CAPM is necessary to estimate the cost of equity i.e. r which will feed into the dividend valuation model. Usually r will be a function of the risk appetite of investors and will generally exceed the cost of debt.

This is a very subjective area and expectations of different investors will vary – e.g. institutional investors, ordinary shareholders and speculators

Lots of hedge funds use the alpha values – i.e. return in excess of CAPM – also known as the abnormal rate of return which can be useful

9. Savings Interest Calculator June 12, 2009 at 2:58 pm

I think there are now a lot of undervalued dividend paying stocks due the global economic fallout. It looks like we're in for a sideways market for some time. As such, I wouldn't be investing in anything that doesn't pay some sort of dividend. Thanks for sharing this formula; it should definitely help find the dividend stocks with the greatest potential.

10. njeru July 13, 2009 at 11:13 am

Just like Joshua had asked,in a case where you don't know the share price (unquoted) how do you get the r?for g you can assume growth in related industries

11. Pika_n2 September 16, 2010 at 5:16 pm

What if the dividend growth rate is negative? As the dividend payout decrease from 10 cents to 5 cents per year? Please advice.

12. NoviceInv January 4, 2011 at 7:23 pm

P=D/r-g : it is obvious if g increases then r(required rate) gets smaller and since the divisor(r-g) decreases, then Div increases and P is larger, may be overvalued in some instances.

I hope that helps from high schooll Algebra.

13. student August 27, 2011 at 12:56 pm

What if g ir greater than r? Does that mean that in event like this, dividend discount model cannot be used? Pls assist. thank you.