Using the Dividend Discount Model to Value Stock

There are many methods in which investor’s determine if a company is worth investing in. They look at a number of different items in a company’s financials, stock price, projections, and demand for its product or service. Finding the right mixture of things to help you develop the perfect model to value stock is important. So, let’s take a look at a couple of models of valuing a company many people use.

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Example:

Company X has common stock

Stock is trading for 50.37 a share

Dividends paid out quarterly at .36 cents a share annually 1.46 per share

Since having one share of this companies X stock there are methods which we can use to determine the share value vs. dividend payout rate based on just the past dividends paid on those shares.

Let’s use the Dividends Discount Model method to help us determine that value. This dividend model takes into consideration only the expected amount of the dividend payment paid out and the required rate of return by dividing the rate of return on the cash flow by the rate of your return. So, if you are an investor looking for approximately 8% return on your investment then when you use this model the stock you are searching for should be worth 18.25 per share ($1.46/.08) to the investor.

The example above starts at a company trading stock at a value of 50.37 per share, but when you add in the dividend discount model it shows a stock value of only 18.25. This means that the model we are using rates that the stock is overvalued quite a bit. There are a couple of different reasons for this.

1. The stock is a popular choice among investors, so investors are willing to pay a premium to own a share of the stock.

2. The company could actually be in debt and still show a respectable stock price just based on the above model. Because even highly indebted companies that are still paying out a consistent dividend make it appear that the company is not in any financial mishaps.

So, with those two flaws in mind any stock you seem to make with this model always double check the companies financials before investing. But, this is a quick and easy way to reduce the amount of stocks you have to sift through to find one with decent earning and dividend payout. The idea of a dividend is that companies pay them out based on the profit that it has made over the year most of the time.

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