How to Use the Dividend Discount Model - dummies

How to Use the Dividend Discount Model

By Matt Krantz

Using the dividend discount model is a great way for online investors to determine whether a stock is on sale. Sometimes investors get so wrapped up in the drama of online stock investing that they lose sight of what they’re buying.

As a stock investor, you’re letting a company use your money to sell goods and services for a profit. If the company makes money, it will ultimately give back your fair share of the profits over time. Typically, that’s done by paying a dividend. Even young companies that don’t pay a dividend now eventually start to as their profits exceed their needs for cash.

And that’s the basis of the dividend discount model approach to valuing stocks. The idea is that most companies pay a dividend. The size of the dividend a company pays, and how quickly it grows, can help you figure out how much a company is worth. Here is a list of handy places on the Internet where you can enter a couple variables and have your computer do the rest:

  • Thomson South-Western: This page offers a free calculator that may appeal to you if you’d like more control of the assumptions being used in the model. The site can tell you how much a stock is worth if you enter just three variables:

    • The most recent dividends: The value of the dividends paid by the company in the most recent four quarters.

    • The required rate of return: This is the return you’re expecting from the stock. If it’s a risky stock, your required rate of return might be 15 percent or much higher. And if it’s a conservative stock, you might have a required rate of return of less than 10 percent.

    • Expected growth rate: This specifies how rapidly you expect the company to boost its dividend. You can either use the rate the company has increased dividends in the past or use its expected earnings or dividend growth rate.

      The calculator spits out how much it thinks the stock is worth based on the data you entered.

  • Damodaran Online: NYU Finance Professor Aswath Damodaran provides an entire page of financial spreadsheets to keep your computer more than happy crunching numbers. If you scroll down to the Focused Valuation Models area, you see a simple Stable Growth, Dividend Discount Model spreadsheet. Click the ddmst.xls link and the spreadsheet should open. You need to enter the cells highlighted in yellow, and the spreadsheet does all the math for you.

The dividend discount model is pretty clever and is used by many serious investment professionals. But the model has some big problems. The model is extremely sensitive to your assumptions, especially the required rate of return or discount rate that you enter.

The discount rate is the return you demand in return for investing your money in the company. If you enter a discount rate of 10 percent, you get a wildly different answer than if you enter 12 or 8 percent. And good luck determining what a company’s growth rate will be. Still, it’s a useful tool to get a general understanding about a fair value for a stock.