Stock prices rise and fall constantly, and many investors never seek to tie the movements of share prices to the fundamental health of the underlying company. Yet a stock's price reflects the market's beliefs about how well the company is likely to do in the future, and with the help of theoretical models, you can calculate a growth rate based on the stock price and past financial performance.
The discounted dividend model of stock valuation
There are many valuation models that attempt to determine the appropriate value of a stock. One of them is the discounted dividend model, which determines its value based on estimates of how much the stock will pay in dividends throughout its corporate existence. Expected future dividends are discounted by an appropriate interest rate in order to translate all figures to present value.
In particular, research from Professor Myron Gordon in the 1950s and 1960s established a relationship between a company's stock price and its dividends. According to the Gordon model, the price of a stock equals its dividends over the following year, divided by the difference between the cost of equity capital for a company and the expected annual dividend growth rate in the future.
For instance, assume that a company expects to pay a dividend of $2 in the next year, with a 10% cost of equity capital and no expected dividend changes in the future. The model would calculate the stock price as $2 / (10%-0), which equals $20.
What the stock price says
The Gordon model allows for the fact that the market might put a price on a stock that's different from what you might estimate using the equation above. A higher stock price than predicted implies a faster growth rate than assumed, and a lower stock price implies a lower growth rate.
Again using the above example, say that the actual stock price is $40. That implies that the expected dividend growth rate is higher than the 0% shown above. In this case, the $40 stock prices implies a dividend growth rate of 5%, as $2 / (10%-5%) = $40.
There are limitations on using the Gordon model. The most obvious is that not all stocks pay dividends, and so you must use a substitute measure such as earnings or cash flow to apply similar valuation techniques. Also, assumptions about a constant growth rate indefinitely into the future aren't very realistic, and changes in the cost of equity capital can also result in changing stock prices even under the model's own terms.
Nevertheless, you can get at least an idea of implied growth rates stemming from changes in the stock price. The key takeaway for investors is that if you disagree with the growth assumptions that a given stock price implies, then you can make stock trades to take advantage of that disparity if you're right.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at [email protected]. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.