The dividend discount model is a widely accepted financial tool used to evaluate stocks based on the net present value of future dividends.
It analyzes and makes assumptions about growth in dividends and interest rates. Yes, it speculates, but what sets it apart from other tools is its ability to accurately compare specific numbers based on the given data.
The dividend discount model can only be applied to stocks that pay dividends.
Dividends are a 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 the financial strength to continue paying dividends.
The dividend discount model can also help investors decide if the future growth in dividends is worth the investment today. The concept of the time value of money is crucial in calculations related to the dividend discount model. Future growth in dividend payments is discounted to the present value of the stock to see if the stock is undervalued or overvalued.
The basic dividend discount model formula states that:
There are no two stocks alike, so the 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 dividends until infinity. The constant growth dividend discount model assumes that the company will grow, so the dividends will also increase.
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. The formula for the 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 a 2% growth rate.
Using the dividend discount model, we just figured out the stock’s current price, which is $15. Now let’s say that the stock is selling for $12, which makes the stock undervalued. If the stock were to be $18, we could assume it is overvalued.
It’s a good idea to buy an undervalued stock because of the amount of future cash flows it can generate. Using the dividend discount model, it is straightforward to identify growth or income stocks that can prove profitable if the investment is made in the present.
On the other hand, one has to keep in mind that the dividend discount model is highly speculative and based on various assumptions. In theory, it is one of the best financial tools available to investors, but in the real world, it is better to use a wide range of tools to evaluate stocks.
Risk in the stock market will always be there, but financial tools like the dividend discount model help us make intelligent decisions based on our information.