Stock AnalysisThe Dividend Discount Model (Gordon Equation) calculates the intrinsic value of a stock based on the present value of a company’s future dividends. The model is a powerful investing tool to evaluate if a stock is over or undervalued compared to the market price. Professional investors use the Dividend Discount Model (among others) to value a stock, but for some reason casual investors have a habit of looking at a stock’s price chart to determine if a stock is a good value. The ill-fated chart approach has caused many casual investors to lose a bundle, after all - how can you profitably drive your portfolio if you’re focused on the rear view mirror?

This post is divided into the following sections: Dividend Discount Model’s equation, a sample valuation using Microsoft, and problems with the model.

The Dividend Discount Model

Where:

D1 (Estimate of next year’s dividend) = Current annual dividend * (1 + g)
r (Required Rate of Return for the Stock) = Real Risk Free Rate + (Market Return - Real Risk Free Rate) * Beta of Stock
Real Risk Free Rate = 52-Week T-Bill Yield**
Market Return = Estimate for the stock market’s return in the next year
g (Dividend Growth Rate) = Estimate for the stock’s dividend growth rate (you may calculate g by using the growth of the dividend in the past)

** 52-Week T-Bill Yield - You can find the yield by going to the U.S. Treasury Direct website, selecting the most recent year under auction date > 52-week bills > PDF of the latest auction results.

Sample Valuation

Here’s a sample valuation of Microsoft (MSFT) using the Dividend Discount Model..

The Dividend Discount Model requires two major assumptions - the return on the stock market for the next year and the growth rate for the stock’s dividend. In this example I will use an optimistic 12% expected return for the stock market, and a 10% dividend growth rate for Microsoft, based off their 2008 dividend growth. When you run the equation you can change these values to high, medium and low numbers, so that you can see a range of strike prices based on differing 1 year outcomes for the stock market and Microsoft’s dividends.

g (growth rate) = 2008 dividend / 2007 dividend
= .44/.40
= 10%
D1 = Current Dividend * (1 + g)
= $.52 * (1 + .1)
= $.572
r (required rate of return) = risk free rate + (market rate - risk free rate) * MSFT’s beta
= .55% + (12% - .55%) * 1.01
= 12.12%
Dividend Discount Model = D1 / (r - g)
= $.572 / (.1212 - .1)
= $26.98

Microsoft closing price as of last Friday July 24, 2009 was $23.45, so with a $26.98 valuation from the Dividend Discount Model, Microsoft would be considered undervalued.

Problems With the Model

For high-growth stocks, the growth rate (g) may be higher than the required rate of return (r), in which case the suggested stock value would be a negative number.

It is important not to use the Dividend Growth Model by itself, but rather as one tool in the value investing toolbox we’re constantly building on this blog

Feel free to ask me any questions you may have in the comments section below..

5 Intelligent Responses to “Dividend Discount Model, Pro Stock Analysis”

  1. Daniel M. Ryan (2 comments.)

    From what I recall, it’s better to use an estimated growth rate rooted in long-term dividend growth. Some conservative types don’t assume any dividend growth at all, except perhaps for Dividend Aristocrats.

  2. Max Asciutto

    Daniel,

    I agree, using the long-term dividend growth rate should deliver a more accurate estimate compared to one year’s dividend growth rate.

    Moreover, the inaccuracy in the formula is that the future dividend growth rate may have no correlation to past dividend growth, as the bear market of 2008 taught us. For that reason, I like to use the formula with a low, mid, and high estimate for the dividend growth rate to get a range of strike prices.

    Thank you for the insightful comment.

  3. Jacob

    Max,
    Are you sure you are following your correct order of operations to calculate r (required rate of return) in your MSFT example?
    My calculations came out with r=11.57%

  4. Peter

    Max,

    Pretty sure your calculations are wrong! Please check again!

    Peter

  5. QUALITY STOCKS UNDER FIVE DOLLARS (5 comments.)

    Some excellent detailed information on investing in dividend stocks.

Write an Intelligent Comment