Using the Dividend Discount Model to Value Stock By Billy J Best

Methods for evaluating the value of a corporation can be as complex as looking deep into a company's financial statements to determine an accounting value to simply looking at its stock price that it is trading for and the amount of dividends it pays out to stockholders. The latter is a very popular way that individuals should consider looking at in terms of valuing a corporation, this approach can reveal the value of common stock but has some drawbacks too. Take for instance, a hypothetical common stock, XYZ stock; pretend it was trading, as of today, for $50.37 per share. For the past 4 quarters XYZ stock has paid out exactly $0.3650 per quarter in dividends for a total yearly amount of $1.46. Since one share of this common stock is the price of owning a single portion of the XYZ Corporation, methods have been established for showing what this share value is worth based from past dividends paid out.

A simple way to value this XYZ stock is using the Dividend Discount Model (DDM) method. This model takes into account only the expected cash flows in the form of dividends paid out and the required rate of return by simply dividing the expected cash flow by the required rate of return. For instance, say that an investor looking to invest in this stock requires an eight percent return. Using the DDM, their stock should be worth $18.25 per share ($1.46/.08) to a potential stock purchaser.

As stated above, XYZ shares are trading for $50.37 per share, yet, the DDM shows a stock value of only $18.25. Obviously, the DDM shows that XYZ is overvalued in terms of its expected dividend payout. The biggest reason XYZ's stock price could be greater than the DDM price is because XYZ could be a very popular corporation, thus, stock purchasers are willing to pay extra for stock ownership. This is considered a flaw in the DDM because it only takes into account the dividend cash flow. Moreover, a corporation could actually be in debt, and still show a respectable stock price based from the DDM. The reason is because a highly leveraged corporation could still pay out a consistent dividend, making it appear the corporation is not having financial woes.

There are other methods of valuing a company's worth, however, non are perfect. The dividends paid out represent a portion of the profit (most of the time) that a company pays out to its common share owners. So, remember, when using the DDM, make sure to look deep into a company's financial statements for liabilities to ensure that the company is truly as profitable as it appears.