About Valuation of Stocks
There are many ways to value stocks- such as the use of discounted cash flows, relative valuation as well as contingent claim valuation.
Did you also know that there is a simple way to value dividend stocks? And all you need is 3 steps?
The Dividend Discount Model is used by many investors to value stable dividend stock.
The core concept of this financial model is that the value of a stock is the present value of dividends to be received in the future.
Some people also refer to it as the Gordon Growth Model. Myron Gordon and Eli Shapiro founded this model at the University of Toronto in 1956.
You only need three steps to value dividend stock using the model. It is to find out:
- The expected dividends payout next period
- Cost of equity of the stock
- Expected growth rate of dividends in perpetuity
Dividend Discount Model Formula
Value of stock= Expected dividends next period/(Cost of equity-Expected growth rate of dividends in perpetuity)
How to Apply It
Consider Keppel DC REIT, a dividend stock that I bought. It has an expected dividend per share for next period of $0.07. A cost of equity of 8 %, and an expected growth rate of dividend at 4% forever. The value of this stock is:
Limitations of The Model
Dividend Discount model provides a simple approach to value dividend stock. But the limitation is that it is only for firms that are growing at a stable dividend growth rate and that pays dividend.
Since the dividends growth rate to be inputted is expected to last forever, the earnings of the company have to grow at the same rate. Why? Consider a firm whose earnings grow at 3% a year forever, while its dividend grows at 6%. Over time, the dividends will exceed earnings.
On the other hand, if the earnings grow at a faster rate than the dividends, the dividend payout ratio will go down and converge to zero. This is also not an example of a company in a steady state and it will not be suitable for this model.
As you may have noticed, this model is sensitive to assumptions about the growth rate.
The key is to find out what growth rate is reasonable as a stable dividend growth rate. Which is to be inputted into the dividend discount model. This is not an easy task.
Also, if the growth rate of dividend is more than the cost of equity, the value calculated from the model becomes negative. Is this constraint logical?
Common sense says that this constraint is logical because a stable growth rate of dividends cannot exceed the risk-free rate. This is because as a firm grows, maintaining high growth percentage is difficult.
Eventually, the dividends growth rate will be less than the risk-free rate.
Do not forget that this growth rate is the growth rate that we assumed the dividend will grow perpetually. I think it is illogical for the growth rate to be more than the risk-free rate.
Another limitation is that this model would underestimate the value of the stock that consistently pay out fewer dividends than they can afford to.
This is because one of the key inputs of this model is the expected dividends payout. With lesser dividend input, the value calculated would be lesser too.
In your mind, do you already have a feel on what kind of stocks are suitable to be calculated using this model?
This model is ideal for firms with stable dividend growth rate.
The dividend growth rate has to be the one that grows at a slower rate than the risk-free rate. Also not forgetting a well-planned dividend payout policies that the firm’s will abide by.
Finally, since there are correlations between the earnings growth and the dividend growth. Is it possible that we substitute the dividend growth rate to earnings per share growth rate?
Ultimately, valuation is both an art and a science. Do you think this model is reliable?
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