One of the traditional and conventional methods for valuing an individual stock is Dividend Discount model. It is also popularly known as Gordon Growth Model which accepts that a stock is equal to the present value of its entire future dividend future dividend payments. It is very simple and effective in dividend paying stocks.
How it actually works –
The dividend discount model includes few variables –
- Cost of Capital or your predictable return
- Growth rate of the Dividend stream
- Value of the Stock
- Dividends in the neat year
Three variables out of above four will allows you to solve the remaining variables. Actually it solves for the value of a single share of Stock.
Price = Dividends / (Rate of Return – Dividend Growth Rate)
Example – Think a company pays an annual dividend of 1$/share. Assume the dividend grows 6%/year. If Investors seek at least 10% returns on their investments, then what should an investor pay per stock?
Calculating by Referring to our variables shoes that = $1.00/(1.10-1.06). Using simple math results Price = $25. Bottom line is, as long as we pay less than $25 /share and company rises up its dividend at an annual rate of 6% /year, which gives a platform for us to earn 10% return on the investment.
What makes the Dividend Discount model so great and unique –
- Traditionalism – It gives values to the company and makes it pay concentrate only what it pays to the investors. Actually it never interfere in any transaction of the companies it only values the dividend.
- Straightforwardness – It is the easiest way to measure the measure the value of the security. It provides comfort zone to the investors to forecast further.
- Choosiness – It is limited to those companies who pays regular dividend and which are expected increase their dividend at constant rate.
- Compassion – It works fine only if key norms of the model are very accurate.