The dividend discount model is a method of valuing stock shares based fundamentals, that is, based on facts and expectations about a company's business, future cash flows and likely risks. Dividend valuation is one of the oldest and most conservative stock pricing methods still widely taught and used.
Dividend valuation uses a formula to construct the fair value of a company's stock based on its dividend yield. The process of using known factors to determine a price is called "discounting," and dividend valuation is often called the dividend discount model. The purpose, as with any valuation method, is to determine which stocks are cheap, and should be bought, which are expensive, and should be sold, and which are fairly valued and can be held.
There are four basic components to the dividend discount model: the dividend per share, the appropriate rate of return, the beta value of the stock and the dividend growth rate. In most cases, the appropriate rate of return is figured using Treasury spreads, the difference between short-and long-term rates, or some similar market premium rate. The beta value is simply the coefficient expressing the stock's correlation to a broader market benchmark like the S&P 500.
There are many variations on the dividend discount model, many using different methods to calculate the various inputs to the dividend valuation formula. Another major type of valuation procedure is the two-stage or multi-stage models, that account for the fact that the growth rate of a company changes over time. In most cases, a company's early years can be characterized by 30 percent growth per year or more, but mature companies tend to average a steady 6 percent over time, accounting for inflation and GDP increases.
Despite the vast amount of trading that occurs every day the market is open, most Americans with money in the stock market are playing for the long-term through mutual funds and 401(k) retirement accounts. Their strategies tend to be conservative and value-oriented. Fundamental analysis, such as the dividend discount method, can be a very useful tool for identifying dislocations in a market, which occur when stocks are not correctly priced. Though timing the precise move in a stock is nearly impossible for most investors, investors can capitalize on these dislocations over the long-term.
The dividend discount model tends to understate the value of a company with intangible assets like reputation and brand recognition. On the other hand, it may overvalue stocks out of favor with the market. No amount of careful calculation, however, will necessarily predict the future movement of a stock, and assumptions about future growth rates, interest rates, the price of risk and the stability of the market make the model vulnerable to exaggerations.