When you own a share of stock, you own a small piece of a company. You've slapped cash down on the table, trusting the company's management to shepherd it well and provide you with a positive return on your investment. You deserve to be treated well, and you deserve to know that your cash and your risk are being taken seriously by those you've entrusted.

Company executives can give no clearer signal that they understand their duty than through their dividend policy.

The power of payout
Dividends offer you as a shareholder tremendous benefits that go well beyond the actual cash you receive. In addition to being a direct reward to you for putting your capital at risk in that specific company, dividends:

  • can provide inflation-protected income on a large enough capital base.
  • often act as a hedge against stock dilution.
  • acknowledge that management works for shareholders.
  • are difficult to convincingly fake.
  • can be reinvested to compound returns even more quickly.
  • can be used to come up with a value for the overall firm.

In fact, it's that last point that forms the basis of my own favorite value investment strategy, one based in large part on the dividend discount model (DDM). In this system, a share of stock is valued as the net present value of expected future cash flows to the owner. In other words, you give money to the company, in the form of your investment, and the company gives back to you, thanks to its dividends. How much you should pay for the stock depends on how much you expect to get back from the company, discounted by the risks and time associated with keeping your money tied up in the stock.

When it doesn't work
Not every company is a candidate for a DDM analysis, since it requires steady dividends and management's commitment to continue to directly reward shareholders for their financial risks. Companies that don't pay dividends, such as networking leader Cisco Systems (NASDAQ:CSCO), search behemoth Google (NASDAQ:GOOG), and even value maven Warren Buffett's Berkshire Hathaway would be valued close to zero. That's an absurd conclusion, given those companies' strength and market dominance.

For those companies, a discounted cash flow (DCF) evaluation would be more appropriate. The DCF model uses calculations similar to a DDM evaluation, but it bases its data on the company's internal cash flows rather than on its payout to shareholders. This gives it a much wider scope of companies to work with. DCF analysis plays a very strong role in which stocks my friend and colleague Philip Durell recommends in his market-beating Motley Fool Inside Value newsletter. Using the DCF technique, Philip uncovers gems like title insurer First American (NYSE:FAF), whose performance has lapped the market by almost 5-to-1 since he uncovered it.

When it does work
For companies such as real estate investment trusts (REITs), banks, pipelines, and stable manufacturing giants that pay decent, steady dividends, DDM is an excellent model. I happen to prefer DDM, in fact, because it focuses only on what I care about most: How and when do I expect to get my money back?

Some categories are natural fits for DDM analysis. REITs, such as mall operator General Growth Properties (NYSE:GGP), are excellent candidates. Since they're required by law to pay out a significant portion of their earnings to shareholders, they often have high yields with dividends growing in line with earnings. Likewise, pipeline partnerships such as Kinder Morgan Energy Partners (NYSE:KMP) fit nicely with DDM analysis, since shares of these limited partnerships are really nothing more than a purchase of the company's future income stream, not an option on control of the company.

Banks are another place that often fit DDM well. For example, consider banking giant Bank of America (NYSE:BAC). The bank has a decent yield and a long history of paying and growing its dividends. With a payout ratio in the mid-40% range, there is both safety in its payout and room to grow it more, should the company choose to do so. To get an idea of the bank's (split-adjusted) dividend history, see this chart:



1999 $0.93 n/a
2000 $1.03 10.8%
2001 $1.14 10.7%
2002 $1.24 8.8%
2003 $1.44 16.1%
2004 $1.70 18.1%
2005 * $1.90 11.8%
* estimated

I like to see companies that have managed to raise their dividends for several years in a row, especially through the boom and bust of an economic cycle. And from the dot-com blowout of the late 1990s through the subsequent recession and recovery, Bank of America steadily raised its payouts to its owners. That makes it an excellent candidate for DDM analysis. Making the analysis worthwhile, however, requires you as an investor to make projections about what the company will do in the future. Given that there are no guarantees about the future, a decent projection should:

  • be conservative to be realistic.
  • presume a slowdown in growth as the company matures.
  • not expect the company to grow faster than inflation and the economy forever.
  • properly adjust for the risk of investing.

Building the model
To adjust for risk, I use a 12% discount rate for most of my evaluations. The stock market has historically returned somewhere between 10% and 11% annually. I demand a slightly higher figure as compensation for the risk I'm taking on.

For long-term growth, I like to use numbers no higher than 6%. With inflation running about 3% annually and real economic growth about the same over time, using a higher number would presume that the company would eventually take over the world. To be conservative, a number below 6% may be warranted.

For nearer-term growth, I like using dividend growth rates that are no higher than recent history and are in line with analysts' estimated growth rates for the next few years. In Bank of America's case, the current five-year estimates of analysts polled by Thomson First Call range from 7.6% to 12%, with the median estimate at 9%. Given that I think Bank of America still has some room to increase its payout ratio, I feel comfortable using a figure at the high end of the range -- albeit one below the company's recent dividend growth rate.

With that in mind, here is my current DDM analysis of Bank of America:

2006 $2.09 11% $1.87
2007 $2.32 11% $1.85
2008 $2.58 11% $1.83
2009 $2.86 11% $1.82
2010 $3.17 11% $1.80
2011 $3.49 10% $1.77
2012 $3.84 10% $1.74
2013 $4.22 10% $1.71
2014 $4.65 10% $1.68
2015 $5.11 10% $1.65
2016 $5.52 8% $1.59
2017 $5.96 8% $1.53
2018 $6.44 8% $1.48
2019 $6.95 8% $1.42
2020 $7.51 8% $1.37
Perpetual * $132.64 6% $21.64
Total NPV $46.72
* Stable model value calculation

Given that Bank of America's stock trades around $46 and I value the company at $46.32, I think Bank of America is appropriately valued now. It's no longer the deep discount bargain it was when I found it with DDM and bought it for myself in late 2003. Nonetheless, I can use this model to track whether the stock's price ever again gets out of whack with my value estimate -- and to adjust my portfolio accordingly.

What's next?
While the bargain price for Bank of America may be gone, there are always values lurking in the market. Judicious use of the dividend discount model and its cousin, the discounted cash flow model, can help you dig out the bargains that lurk out there today. Finding those bargains today will help you earn profits tomorrow.

Join the Fool's value expert Philip Durell on as he uses the discounted cash flow model to uncover companies trading below their true worth. Click here for a free 30-day trial to Inside Value.

This article was originally published on Oct. 4, 2004. It has been updated.

Fool contributor and Inside Value team memberChuck Saletta owns shares of Bank of America and Kinder Morgan Management (NYSE:KMR), which is related to Kinder Morgan Energy Partners. Chuck's wife owns shares of General Growth Properties. The Fool has adisclosurepolicy.