Everybody knows the stock price but only a few can understand how much it is worth. When we buy shares of a stock, we seem to agree with the price based on various technical levels or simply because our broker has said so. Only a few investors dig deep to know what its true value is. When valuing a financial asset, its price today should reflect all the future benefits an individual will derive from it. A company’s current share price should not be anything other than the future benefits, discounted by the current interest rate. If the price is different, the market is then not efficient and some investors can make a lot of money through arbitrage.
The Dividend Discount Model (DDM) is a simple method to value a stock. It is one of the most popular methods used by valuation consultants when doing a stock valuation. The returns an investor gets by purchasing shares in a stock, comes in the form of dividend payments and capital gains. This implies that a stock paying a stable dividend each year can be valued using the principle discussed above. The future benefits from the shares, which come in the form of dividends are discounted to obtain the present value which is deemed to give the value of the stock.
DDM only takes into account the expected cash flow, which comes in the form of dividends and the required rate of return. To get the worth of the stock, we simply divide the expected cash flow and the expected rate of return. Assume we have a certain stock from a particular company trading at $40.21 per share. For example, if the stock was paying an annual dividend of $1.62 and requires a 7% return, then the stock should be worth $23.14 per share ($1.62/0.07) to any potential buyer.
In the above example, DDM shows that the stock is overvalued in terms of its expected dividend yield. The biggest reason why the stock’s price is higher than DDM, is that the company could be very popular and investors are willing to pay extra for the stock. This is one flaw of the DDM as it only takes into account the dividend payments. It is important to note that the method only works when valuing stocks which pay stable dividends. This puts out companies which pay dividends sporadically or do not pay dividends at all. The DDM can also show respectable stock prices for corporations in debt, as highly leveraged companies can still pay high dividends, making it appear that they don’t have financial woes. So it is prudent to look deep into the company’s financial statement for liabilities when using DDM.