Valuing Stock With The Dividend Discount Model

Determining on his or her own what value to place on each stock can be tricky for an investor. For stocks that pay out dividends the dividend discount model can help. This calculation is one of the oldest methods of stock valuation, but is only as good as the figures assumed. The dividend discount model values a particular stock by taking the dividend figures predicted for the future and converting them to a current value. If this mathematical equation shows a higher DDM than the current market price of the stock, that stock is considered undervalued. It is a stock to buy. The equation is simple: expected dividend per share divided by the difference between the discount rate and dividend growth rate.

Of course, to complete the calculation, the investor must understand the terms and have access to dividend prediction help. Discount rate means the interest rate used to determine the current value of future cash. If, for instance, a stock were expected to pay out $300 one year from now, and a discount rate of 10 percent was assumed, the present value of that $300 would be $272.72. The math would be $300 divided by 110 percent.

This dividend growth model can be complicated, as with its multistage version when the stock might falter here and there, and change value in stages. With a two or three stage dividend valuation model, the stock might actually show a decrease in value at one or more stages. A more difficult calculation, it is nevertheless considered to be more reliable for investment decisions.

While widely used for many years, the dividend discount model requires speculative assumptions that might or might not be accurate. The most obvious issue is whether the correct discount rate is used. Even an investor that closely follows the writings and advice of stock experts and participates in trading clubs must use a “best guess” figure as his or her discount rate. If the figure is wrong, the current value of the stock is wrong. On the other hand, if the valuation is considerably above the trading price for the stock the investor can assume the stock is undervalued. She or he might just not know the accurate undervaluation.

While the dividend discount model is not a guarantee for stock valuation, it is a method long used by trading experts. The dividend discount model can help amateur investors think through the decision of what to buy and when. They must realize that this valuation model does not guarantee success, however. The stock market offers no guarantees, but the dividend discount model can help.