An investor or analyst typically values an investment based on its expected future cash flows. The dividend discount model measures the value of a company’s stock based on its dividends — which represent cash flows to an investor — growth rate and investors’ required rate of return. If you know a stock’s dividend payment, required rate of return and its value based on the dividend discount model, you can calculate its expected growth rate, which is equivalent to the company’s growth rate as a whole. A higher growth rate increases the chance that a stock will increase in value.
Determine a stock’s known dividend payment per share for the next year, required rate of return and its value based on the dividend discount model. The required rate of return is the return an investor could get on a similar investment. For example, assume a stock will pay a $2 per share dividend over the next year and has a 10 percent required rate of return and a $30 value based on the dividend discount model.
Substitute the known values into the dividend discount model: value = dividend/(required rate of return - growth). In this example, you get the equation 30 = 2/(0.1 - g). In the equation, “g” represents growth.
Multiply both sides of the equation by the right side’s denominator to eliminate the fraction. In the example, multiply both sides of the equation by (0.1 - g), which leaves 30(0.1 - g) = 2.
Multiply the stock’s value by each term inside the parentheses. In this example, multiply 30 by 0.1 to get 3, and multiply 30 by -g to get -30g. This leaves 3 - 30g = 2.
Subtract the number on the left side of the equation from both sides to move it to the right side of the equation. In this example, subtract 3 from both sides to get -30g = 2 - 3, which leaves -30g = -1.
Divide both sides of the equation by the number next to g to solve for g. Then multiply your result by 100 to convert it to a percentage growth rate. In this example, divide both sides by -30 to get g = -1/-30, which results in g = 0.033. Multiply 0.033 by 100 to get a 3.3 percent growth rate.
- The Motley Fool; Dividend Discount Model; John Del Vecchio; April 2000
- New York University, Stern School of Business: Chapter 13 — Dividend Discount Models
- Myron J. Gordon. "The Investment, Financing, and Valuation of the Corporation." R.D. Irwin, 1962.
- Walmart. "Dividend History." Accessed August 3, 2020.