One of the most intimidating things for the new investor can be getting a grasp on how to properly value a stock. How do you know whether a company’s share price is too high or too low?
There are several methods for determining this, and the proper approach can vary depending on the type and size of a company you are evaluating. Some methods look only at the company’s fundamentals, while others are based on comparing one company to another.
One of the most common methods for valuing a stock is the dividend discount model (DDM). The DDM uses dividends and expected growth in dividends to determine proper share value based on the level of return you are seeking. It’s considered an effective way to evaluate large blue-chip stocks in particular.
What Is the DDM Formula?
Several versions of the DDM formula exist, but two the basic versions shown here involve determining the required rate of return and determining the correct shareholder value.
- Stock value = Dividend per share / (Required Rate of Return – Dividend Growth Rate)
- Rate of Return = (Dividend Payment / Stock Price) + Dividend Growth Rate
The formulas are relatively simple, but they require some understanding of a few key terms:
- Stock Price: The price at which the stock is trading
- Annual Dividend Per Share: The amount of money each shareholder gets for owning a share of the company
- Dividend Growth Rate: The average rate at which the dividend rises each year
- Required Rate of Return: The minimum amount of return an investor requires to make it worthwhile to own a stock, also referred to as the “cost of equity”
Generally, the dividend discount model is best used for larger blue-chip stocks because the growth rate of dividends tends to be predictable and consistent. For example, Coca-Cola has paid a dividend every quarter for nearly 100 years and has almost always increased that dividend by a similar amount annually. It makes a lot of sense to value Coca-Cola using the dividend discount model.
Determining Required Rate of Return
You may know in your gut what kind of return you’d like to see from a stock. But it helps to first understand what the actual rate of return is based on the current share price. That formula is:
Rate of Return = (Dividend Payment / Stock Price) + Dividend Growth Rate
Let’s use Coca-Cola to show how this works:
In of July 2018, Coke was trading at nearly $45 per share. Its annual dividend per share was projected to be $1.56. Coke has increased its dividends by roughly 5% per year, on average.
Thus, the rate of return for Coke is:
($1.56/45) + .05 = .0846, or 8.46%
In other words, an investor can expect an 8.46% annual return based on its current share price.
2. Determining Correct Shareholder Value
If your goal is to determine whether a stock is properly valued, you must flip the formula around.
The formula to determine stock price is:
Stock value = Dividend per share / (Required Rate of Return – Dividend Growth Rate)
Thus, the formula for Coke is:
$1.56 / (0.0846 – 0.05) = $45
As you can see, the formulas match up, but what if, as an investor, you would like to see a higher return? Let’s say you want to see a 10% return. What would the appropriate price be based on the current dividend rate and growth rate?
$1.56 / (0.10 – 0.05) = $31.20
Thus, you may decide that as an investor, it makes more sense to wait for Coca-Cola’s price to drop in order to get the desired return. Conversely, another investor may be comfortable with a lower return and would not object to paying more.
Limitations of the DDM
The dividend discount model is not a good fit for some companies. For one thing, it’s impossible to use it on any company that does not pay a dividend, so many growth stocks can’t be evaluated this way. In addition, it's hard to use the model on newer companies that have just started paying dividends or who have had inconsistent dividend payouts.
One other shortcoming of the dividend discount model is that it can be ultra-sensitive to small changes in dividends or dividend rates. For example, in the example of Coca-Cola, if the dividend growth rate were lowered to 4% from 5%, the share price would fall to $42.60. That’s a more than 5% drop in share price based on a small adjustment in the expected dividend growth rate.
So if you're going to use DDM to evaluate stocks, keep these limitations in mind. It's a solid way to evaluate blue-chip companies, especially if you're a relatively new investor, but it won't tell you the whole story.