Tuesday, July 26, 2011

How to Value Stocks? The Dividend Discount Model (DDM), a Rational but Clumsy Approach that Focuses on Dividend Growth.

Often investors ask me how they should "value" a stock. There are a number of interconnected ways that the Intelligent Investor can value a stock and determine what they believe to be a fair value for it. One way that has fallen out of favour in more recent years is the traditional approach of the "Dividend Discount Model."

(Fair Stock Price) = (Current Annual Dividend) / (r) - (g)

Be aware, the dividend discount model has a number of assumptions that must be made by the investor in order to arrive at your "fair price," but it is a nice start, and it at least ensures that the investor engages in some rational analysis at the start of their quest for the right company.

The first assumption that the Intelligent Investor must make when using the dividend discount model (ddm) is something called the "discount rate," (r). I like to think of the discount rate as the amount of money that you could rationally be making if you simply invested elsewhere, plus inflation. For this rate, I like to use a corporate bond index, other investors often use other metrics, but like I said, the ddm has many inherent assumptions that must be made. Currently, the rate on High Yield Corporate Debt in the United States is 7.35% (Bloomberg).

The second assumption that must be made by the Intelligent Investor is the growth rate of dividends, (g). Here, it is wise to use the historical 5 year average of the stock you are examining. However, remember that dividends can be reduced! So be very conservative in your estimates of dividend growth. The more stable the company and business, the more accurate this will be. To add an extra level of caution, I also like to subtract the current inflation rate, which is always making your money less valuable in the future than it is now. Currently, inflation is 3.1% in Canada.

Now here is a real world example to illustrate how the model works.

Coca-Cola is a name most are familiar with.


(Fair Stock Price) = (Current Annual Dividend) / (r) - (g)

FSP = $1.88 / (0.0735) - (0.09 - 0.031)
FSP = $1.88 / (0.0735) - (0.059)
FSP = $1.88 / (0.0145)
FS = $129.66

Clearly, since Coca-Cola (NYSE: KO) is trading at $69.31, Coca-Cola's Fair Value seems extremely high. Why did the model produce this result. Two main reasons. First, very low current bond rates have created little reward for investors seeking an alternative to stocks. This makes stocks seem more valuable. Secondly, Coca-Cola's unusually high average of dividend increases. Coca-Cola has a very strong record of increasing its dividend every year, which makes it appear particularly valuable when a model that favours dividends is utilized. 

Happy Investing : )

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