While the dividend discount model is often cited, I noticed there aren only a few examples on the web about how the formula is used, and most of them over complicate the formula a bit.
If you haven't heard of the formula before, the dividend discount model is a way to calculate the present value of a company's future dividends to help come up with an intrinisic price per share of the stock. Comparing that intrinisic value of the stocks dividends with the current market price can be a useful tool in your belt to decide if a company is under or over valued.
Here are the variables we'll use to calculate the DDM:
- D1 - the company's estimated dividend next year
- r - the required rate of return for the company equal to the risk free rate + (mkt return - risk free rate) * company's beta. We'll use the 3 month treasury bill as our risk free rate, which you can get from this link to the treasury website.
- g - the company's historical dividend growth rate
Here's the formula:
r - g
We'll do a real life example of the formula with GE.
So here are the variable's filled out with GE's information:
- D1 - GE's current dividend is $.96 (as of Feb 2017), last year it was $.92; so we'll estimate that GE's dividend in 2018 will grow the same 4.1% and be $1.00 next year
- r - .93% (3 month t-bill as of 5/2017) + (8% est. GE growth rate [using trailing last 5 years] - .93%) * 1.18 (GE's Beta
- g - 4.1%
So are final calculation looks like:
(.0093 + (.08 - .0093) * 1.18) - .041
Which gives us a share price of $19.33. Currently, as of 5/22/2017 GE is trading at $28.18, so the dividend discount model would lead us to believe that GE is currently overpriced.
Please let me know if you have any questions about the dividend discount model or it's usage.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.