The 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?
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.
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.
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..