STOCK TALK: The Dividend Discount Model
Posted on February 13, 2007 at 22:45 PM EST

The Dividend Discount Model [DDM] is taught in most corporate finance courses and is also widely used by brokerage firms, asset managers, and other financial institutions. It is an equity valuation model and is based on the assumption that a value of a stock today is equal to the present value of future cash flows. The model isn't perfect. Nevertheless, it is generally accepted within the investment community and widely used. Consequently, the DDM deserves a bit of discussion and is the subject of this week's Stock Talk.

According to financial theory, the value of a stock is equal to the present value of future cash flows. Stocks are bought, not only for the cash flow that they generate today, but also for the cash flow expected from the company in the future. The cash flow to shareholders is in the form of dividends and the value of a stock is therefore the present value of future dividends. A dividend is a periodic payment to shareholders that is paid in a fixed amount for each share held. It represents a portion of the company's profits that is passed on to stockholders.

The Dividend Discount Model is used to calculate the value of a stock based on future dividends. The math behind the formula lies outside the scope of this article (but can be found in most corporate finance or investment textbooks.) The dividend discount model doesn't factor in intangible assets. Instead, it looks only at dividends and expectations about the future cash flows from those dividends. The goal is to determine if a stock is a good buy (if it is trading at a price lower than the model suggests) or a bad buy (if the stock is trading at a price higher than the model suggests.)

ValueGain software from Hubb Corp. makes it easy to compute the theoretical value of a stock using the Dividend Discount Model. Subscribers can find the DDM in the SuperValue Calculator. For example, Figure 1 shows the fundamental data and theoretical value for Federal Express (FDX). Using the software's Dividend Discount Model, the stock is worth \$143.45 a share, compared to a current market price of \$125.89. So, according to DDM, the stock is currently undervalued by 14%.

click here for larger view

Figure 1: ValueGain SuperValue Calculator

A drawback to the traditional DDM model is that it is based on the simplifying assumption that the dividend growth rate of the company will remain constant. In reality, most corporations pass through a life cycle with different dividend payoutsâpaying out very little in earnings in the early stages of life and paying out bigger dividends once mature. As a result, some investors prefer to use a multi-stage growth DDM model rather than a simple one that assumes that growth will remain constant. Nevertheless, the important point to take home is that, while investment managers, brokerage firms, and other institutions have used the DDM for years, with software like ValueGain, the same analysis is available to ordinary traders like you and me.

Frederic Ruffy
Senior Writer & Index Strategist
Optionetics.com ~ Your Options Education Site

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