The Curious Investor

After the last few posts trying to connect the source of stock “value” to dividends, it would only make sense that one could value individual stocks through their dividends (or anticipated dividends). And you can!

The method is actually very simple. The value of a stock, or anything else for that matter, ought to be equal to the present value of all future benefits that an investor can expect to receive from owning the stock. Now, for a short term trader, these benefits could come from expectation of a higher selling price later (speculation about future price). But, if you were to buy and hold for an infinitely long period, the future benefits would come from all the dividends to be paid to you as a shareholder. When doing this analysis with dividends, you are using what is known as the discounted dividend model for valuation.

The Zero Growth Model
The simplest way of valuing a stock based on its dividend is the zero growth model. Basically, take the stock’s dividend right now and assume it never increases but will continued to be paid on a regular basis from now till the end of time. Then decide on a rate of return you expect from a longterm investment. Generally, this ranges from 8 - 12%. The price of the stock can then be calculated as follows:

P = D / r

where D is the annual dividend and r is the rate of return demanded by investors.

Constant Growth Model
Now, if you assume that the stock’s value will grow by a certain percentage every year, you can factor growth into the model with this simple equation:

P = D/(r-g)

where g is the constant growth rate expected in the future.

Variable Growth
More realistically, dividends will grow at variable rates over the future. Obviously, it’s very difficult to predict growth rates, but you can likely anticipate dividend growth over the next 5 to 10 years with some degree of accuracy. Simply discount each future dividend by (1+r)^N where N is the period of the future dividend. And, make an assumption on a terminal growth rate for the dividends at the end of the years you can reasonably project. Sum the discounted values of the anticipated dividends and then add 1/(1+r)^N * Df/(r-gf) which represents the dividends being paid in the future when growth has leveled off.

As you can tell, these models for valuation are fairly simple. Furthermore, they depend heavily on growth rate and required rate of return. For example, if a stock is paying a $1 annual dividend and we take the zero growth model. We can get valuation ranging from $12.50 to $10 for the stock if we take a required rate of return between 8% and 10%. While this doesn’t seem like much on a nominal basis, it does correspond to a 25% difference in price.

Thus, the discounted dividend model for stock valuation is not necessarily to be used for hard and fast valuations, but it can give you a general idea of what to expect from your investments. And, it can definitely help to establish a baseline value for your long-term stock positions.

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