The dividend discount model is used to calculate the share prices of stock from dividends. It uses a discount rate to convert all of the stock’s expected future dividend payments into a single, theoretical stock price, which you can compare to the actual market price. If the market price is greater than the model’s price, the market may be overvaluing the stock. If the market price is less than the model’s price, the stock may be undervalued.
Read More: The Advantages of Stock Dividends
Calculate Share Prices from Dividends
Calculating share prices from dividends involves several steps. They are set out in the example below.
- Visit any financial website that provides stock information and determine the total dividends per share a company expects to pay over the next year, called its forward annual dividend rate. For example, let’s assume a company expects to pay $1.50 per share in dividends over the next year.
- Estimate the required rate of return of the stock, which is the minimum rate of return you would require to invest in the stock. It is also the return you could earn on a similar stock or investment. A stock with more risk has a higher required rate of return, while a stock with less risk has a lower required rate of return. In our example, we’ll choose a 10 percent rate of return on the stock.
- Estimate the stable rate at which you expect the company and its dividend payments to grow per year forever. A company may provide a target growth rate in its annual report. If not, you can make your own estimate based on your future expectations of the company’s growth. We will assume the company’s dividends will grow at 2 percent per year forever.
- Substitute the values into the dividend discount model: stock value = dividend per share/(required rate of return - growth rate). In this example, substitute the values to get: stock value = $1.50/(0.1 - 0.02). Subtract the growth rate from the required rate of return. Next, subtract 0.02 from 0.1 to get 0.08. This leaves: stock value = $1.50/0.08.
- Divide the dividend per share by your result to calculate the stock’s value. In this example, divide $1.50 by 0.08 to get a stock value of $18.75. Compare the model’s price to the market price. In this example, if the market price is $15 and the model’s price is $18.75, the market may be undervaluing the stock.
Dividend Discount Model Limitations
The dividend discount model may not be the best option for valuing stock in all companies. This model is inappropriate for companies that don’t pay out dividends. Companies that have only been paying out dividends for a short time will not provide the best indications to potential investors using this method.
Use Multiple Tools to Choose Stocks
The dividend discount model’s output stock value is sensitive to its estimates. Use the model to supplement other stock selection tools, including your diligence in researching companies, instead of a sole deciding factor.
- The dividend discount model works only for stocks that pay a dividend.