The most intimidating thing to do for stock investors is how to properly value stocks. There are methods to value stocks, depending on the type and size of the company. One of the common methods is the dividend discount model (DDM).
DDM expects the growth in dividends to know the value of the proper shares depending on the return you want to get. This method is effective to value stock, especially large blue-chip stock.
The Formula
The formula to calculate value stock using DDM is relatively simple, however, the understanding of a few terms bellow is essential.
- Stock Price: The price that the stocks are trading.
- Annual Dividend Per Share: Thu amount of money given to shareholders for each share of the company they own.
- Dividend Growth Rate: The average rate of the dividend rises every year.
- Required Rate of Return: The minimum amount of return expected by the investor to own the stocks. It usually also refers to the “cost of equity.”
There are several existing DDM formulas you can use. Here are the two most popular formulas.
- Stock value = Dividend per share / (Required Rate of Return – Dividend Growth Rate)
- Rate of Return = (Dividend Payment / Stock Price) + Dividend Growth Rate
DDM is best used to calculate the value of blue-chip stocks since their dividends are consistent and predictable. Take Coca-Cola for example, its dividend has increased at a similar amount annually.
Limitation of the DDM
The DDM, however, is not good for some companies. For instance, there is no way you can use DDM on any company that does not pay a dividend.
Besides, it is also difficult to use this model on new companies which just started to pay a dividend. Additionally, you also can’t use this method on companies that had inconsistent dividend payouts.
Lastly, this method is also highly sensitive to small changes in dividend or dividend rates.
