Monday, November 27, 2006

Determining the Valuation of Dividend Paying Stocks

An important aspect to investing in stocks is attempting to determine the stocks appropriate valuation. Following is information covering the analysis and valuation of dividend paying stocks.

The most common method used in valuing dividend paying stocks is to use the Dividend Discount Model (DDM), commonly referred to as the Gordon Model. The basic tenant of the model is a company's stock is equal to all of that company's expected future cash flow (dividends in this case) discounted back to the present (time value of money concept) using an appropriate discount factor. More information on the DDM approach can be found here.

The following website contains a Dividend Discount Model calculator to assist one in determining an expected fair value of a particular stock: dividend discount model site is not active at this time-April 16, 2008)) The site answers the question of why use the DDM:

"The dividend discount model (DDM) is a widely accepted stock valuation tool found in most introductory finance and investment textbooks. The model calculates the present value of the future dividends that a company is expected to pay to its shareholders. It is particularly useful because it allows investors to determine an absolute or "intrinsic" value of a particular company that is not influenced by current stock market conditions. In contrast, most target prices published by analysts are set on a relative basis, based on the valuation of comparable companies. The DDM is also useful because the measurement of future dividends (as opposed to earnings for example) facilitates an "apples-to-apples" comparison of companies across different industries by focusing on the actual cash investors can expect to receive. Although it is conceptually simple, the DDM is not widely used except by some institutional investors because it can be cumbersome to apply without the necessary data and analytical tools. makes the DDM accessible to all investors to determine whether they think a particular stock is over or under valued based on its dividend potential.

The Dividend Discount Model is also known as the "Gordon model" named after professor Myron J. Gordon who popularized the model. Professor Gordon wrote about the model in a book he authored in 1962 titled The Investment, Financing and Valuation of the Corporation. Since then the model has appeared in virtually every investments textbook. In his book titled Investment Valuation, Aswath Damodaran, a professor at New York University states: "In the long term, undervalued (overvalued) stocks from the dividend discount model outperform (underperform) the market index on a risk-adjusted basis." Although no investment model works for all stocks all of the time, the dividend discount model has proven to be a reliable way of selecting stocks that on average will perform relatively well on a long-term basis. It should be among the tools that investors use to select at least some of the stocks in their portfolio."
A more flexible and detailed DDM program can be found by clicking here. The Excel file to review is named divginzu.xls in the section of the table titled "All-in-one Valuation Models". A review of the inputs in the Excel file noted previously will provide a more comprehensive understanding of the DDM concept for the investor wanting to analyze their own stock investments.

This brief post does not do justice to the complexity of valuing stocks using the DDM approach. For instance, all stocks do not pay a dividend and the dividend grow rate is not level for companies. There are variations of the DDM to account for these differences and I will cover these topics in future posts. In the interim, if a reader has specific questions on the DDM or topics to focus on in the future, leave me a comment or email.


Poor Boy said...

I've been trying to learn more about the DDM lately, and built myself an excel spreadsheet to calculate fair value for me. However, when a company's dividend growth is too high (say, 14%), or their dividend is too high (20%), I get a negative value (stock is worth -$384.00, perhaps). I wondered if this was a flaw in my understanding of the formula, or a limitation of DDM?

David Templeton, CFA said...

Poor Boy,

You have encountered the limitation in the "constant" growth DDM. There is a "two-stage" DDM to account for companies that have an initial high growth period for the dividend. Following is a link to an article describing how to apply this model to high growing dividend growth stocks.

Essentially, one calculates the dividend for each year of the high growth period and discounts these results back to the present using a present value calculation. Then a value is calculated for the dividend in the subsequent stable growth phase using the "constant" DDM. The result of the two calulations is added together to determine the stock value.

I hope this helps.

Goth said...

Dear David,

My question is about the dividend growth model, for constant growth. What formula do you use when your growth rate,g, equals your discount rate,r ?

David Templeton, CFA said...


For the DDM to hold, the formula requires that g < r . Another valuation method needs to be employed to ascertain whether a stock is over/under valued when g is not less than r. One can use a free cash flow analysis or Ben Graham's favorite of finding companies that trade below their "net current asset value." There are other valuation model as well.


Anonymous said...

I am a student trying to understand Corporate Finance! I have done an evaluation of book value and the Gordon model of a stock and find a huge difference. Why would the book value be a lot (3X)higher valuation than the Gordon model? what am I missing?