Determining Intrinsic Stock Value Using the Dividend Discount Model

Posted on February 24, 2014 by Dr. David Edward Marcinko MBA MEd CMP™

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By Dr. David Edward Marcinko MBA CMP™

http://www.CertifiedMedicalPlanner.org

DEMM high-def White

The Dividend Discount Model (DDM) is one of the most widely used valuation methods for estimating a stock’s intrinsic value.  A stock can be thought of as the right to receive future dividends. A stock’s intrinsic value is defined as the present value of its dividends under the DDM.

In its simplest form (i.e., zero-growth), the DDM determines a stock’s value by dividing the stock’s dividend by the investor’s required rate of return.  The investor’s required rate of return should reflect current interest rates plus the risk associated with investing in the stock.

Rate of Return

The rate of return determined under the CAP-M [Capital Asset Pricing Model] is frequently used in the DDM.

For example, assuming that ABC Corporation pays a $2.00 dividend per share and that an investor requires a 10 percent return for holding ABC stock, the stock’s intrinsic value is $20 ($2/0.10).

Shortcomings

Shortcomings of the zero growth DDM include the following:

  • The model assumes that the stock’s dividends will remain constant over time.
  • The model assumes that dividends are the only source of return available to stock investors, ignoring the effect of reinvested earnings.
  • The model can only be used to value stocks that pay dividends.
  • The model assumes that the company and the dividends last forever.

Despite its shortcomings, the DDM highlights the point that the stock market is discounting mechanism and that financial investments should be assessed in light of the future cash flows that they are expected to provide investors.

A Variation

One variation on the DDM that may be appealing to healthcare professionals involves determining the present value of a stock’s earnings rather than simply its dividends.

Theoretically, owning a stock entitles investors to a claim on the earnings that are left after accounting for the company’s costs (including interest costs).  A model accounting for a stock’s earnings rather than just dividends may help account for the capital appreciation element of owning stocks because a corporation can either invest its earnings back into the company to pursue growth opportunities or distribute the earnings to shareholders in the form of dividends.

Stock_Market

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4 Responses

  1. Dr. Janecki, on August 23, 2014 at 6:14 PM said:

    Dr. Marcinko,

    Today’s dividend yield is no longer the 4.5 percent you got back in the 1920s. It’s less than 2 percent. (And no, stock buybacks have added nothing to that over the longer term, although they can provide short-term boosts).

    And, modern economic growth no longer looks like the 3.5 percent you got back in the 20th century. On the contrary, it’s been getting slower every decade, and for the past 20 years the U.S. economy has only been growing by about 2 percent a year (plus inflation) or less.

    Meanwhile new companies continue to join the market, costing you, say, 1 percent a year. Based on this, the math says long-term returns from investors are only likely to be about 3 percent “real,” not 7 percent.

    Dr. Janecki

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  2. Bernardo, on November 19, 2014 at 1:41 PM said:

    Dividends: 10 Highest-Yielding S&P 500 Stocks

    Many physicians and other investors would like to own high-yielding stocks that have very low risk. Unfortunately, in the real world, such beasts are extremely rare.

    http://www.financial-planning.com/gallery/fp/dividends-10-highest-yielding-s-and-p-500-stocks-2691177-1.html?utm_campaign=daily-nov%2019%202014&utm_medium=email&utm_source=newsletter&ET=financialplanning%3Ae3361840%3A86235a%3A&st=email

    But, these 10 stocks are the current yield champs in the S&P 500 index.

    Bernardo

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  3. Timothy J. McIntosh MPH MBA CFP®, on February 1, 2015 at 9:03 PM said:

    Ex-Dividend Dates

    Upcoming Ex-dividend dates for Top 100

    http://thedividendmanager.com/

    Timothy J. McIntosh MPH MBA CFP®

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  4. Cliff, on June 30, 2015 at 1:17 PM said:

    Dividends are a powerful investment tool

    Did you know that dividends typically:

    1. Provide an objective measure of a company’s health, value and profitability?

    2. Cannot be manipulated like other accounting items?

    3. Can provide a downside cushion when stock returns fall?

    4. Offer the potential for capital appreciation1—and income growth?

    5. Have historically grown faster than U.S. inflation2?

    Cliff

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