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One of the greatest misconceptions among investors is that valuing the market at any given time is impossible. Many people seem to believe the stock market is nothing more than a betting parlor where today's price or tomorrow's price is whatever the fickle gods of Wall Street decree it to be.

Part of this misconception comes from the many voices in the media that are at the extremes in their predictions of where the market is going. On one side, the “stock market bubble” pessimists (who have been saying the same things for the past 5 years) are predicting that the market is overvalued 25% or more. On the other hand, many in the bullish crowd are saying the market is as much as 25%undervalued.

Who are investors to believe?

At DCM, we use several valuation tools that have proved their worth to us over the past 15+ years. While it is not possible to precisely predict where the market should be valued, we have found that it is possible to calculate an approximate valuation within a general range. Back testing has shown that our proprietary Dow Jones (DJIA) model has been able to predict more than 90% of the annual movements of the DJIA going back to 1960. That model is currently saying the fair market value of the DJIA is just under 17,000, with a range about 1,000 point either side of that figure.

Another of the models we use is one that has been around for many years. It’s called the “dividend discount model.”

What Is a Dividend Discount Model?

A dividend discount model (DDM) is based on the idea that a long-term investor will value a company based upon the total amount of cash (dividends) that an investment produces in the future, discounted to a present value.

The concept of the dividend discount model was initially provided in John Burr William’s “The Theory of Investment Value.” There are many different versions, but one of the most widely used is a simple formula known as the “Gordon Constant Growth Model.” The Gordon model is now predicting the fair value of the Dow Jones Industrials is approximately 13,600.

Beyond the Gordon Model

While we believe Gordon’s dividend discount model provides a good starting point to determine the Dow's intrinsic value, its weakness is in its name: constant growth. It assumes dividends will grow at a constant rate in perpetuity. Our belief is that dividends will grow much faster than their long-term rate of 5.5% over the next three, five, ten, even 15 years. Indeed, the current Bloomberg estimate of DJIA dividend growth over the next three to five years is 9.2%. In addition, we believe the dividend payout ratio of the Dow Jones companies will rise from their current rate of 32% to 50% in the coming years.

We have made the point repeatedly that dividend growth is likely to outpace earnings growth over the next decade for several reasons:

(1) Historically low dividend payout ratios (measured by the dividend paid divided by earnings). Historically, the DJIA has paid out about 50% of its earnings in the form of dividends. Today, however, companies are only paying out around 32%. As payout ratios continue to increase back to historic levels, the dividend should continue to outpace earnings growth for years to come.

(2) Companies have generated huge free cash flows over the past five years and will continue to do so.

(3) Companies have somewhere near $2 trillion in cash on their balance sheets. That money has to go somewhere – either to reduce debt, buy other companies, buy back shares, or raise dividends. We believe that ultimately companies will elect to decrease their huge cash holdings, and we are confident dividend payments will receive a significant boost.

The past couple of years would indicate that this higher payout ratio is underway. Dividend payout ratios have increased by nearly 2% per year from their lows in 2011. If this trend continues towards long-term levels around 50%, dividend growth should outpace earnings growth by about 1-2% annually over the next 10-15 years.

Assuming earnings growth follows its historical growth rate of about 6.5% annually over the long-term, dividend growth should average closer to 8% in the next couple of decades.

The Three-Stage Dividend Discount Model

To capture the higher rate of dividend growth over the next few years, as well as, the rising dividend payout ratio, we use a three stage dividend discount model.

Using Bloomberg’s three-five year dividend growth estimate of 9.2% as our starting point, we assume dividend growth will gradually fall to its long-term average in 15 years.

We are currently using 9.5% as the discount rate, which is the average annual return of the DJIA over the last twenty years. Plugging all these data points into the model, we arrive at a current fair value of the Dow of roughly 16,800. That is about 3% above its current level. And recall that our other DJIA model, which is based on a comparison of dividend and earning growth compared to price growth over the last 60 years has a predicted value of just under 17,000.

Both models come to the same conclusion: the DJIA is modestly undervalued. In 2013, a large portion of price growth came from valuation catch up. With the Dow now roughly fairly valued, we can expect future price growth will likely be very closely tied to the rate of dividend and earnings growth. That gives us confidence that stocks are still going higher because our estimates for both dividends and earnings suggest solid growth.

Source: How Dividend Payout Ratios Impact Valuation