None of us has a crystal ball that allows us to accurately project the price of a stock in the future. However, if we make a few basic assumptions, it is possible to determine the price a stock should be trading for in the future, also known as its intrinsic value.
Calculating expected price only works for certain types of stocks
For newly established companies with rapid growth and unpredictable earnings and dividends, future stock price is anyone's guess. There is no valuation formula in any finance textbook that could have accurately predicted that Amazon.com's stock price would have risen by 1,200% over the past decade and that Twitter's price would have lost two-thirds of its value just two years after its IPO.
Many investment firms have proprietary valuation models that can help predict price, but these aren't formulas that are universally applicable, and are generally only accurate for a year or two, if at all. There are simply too many variables and possible price-influencing situations that can happen to young companies.
On the other hand, long-established stocks, especially those that have a consistent record of dividend payments and increases, aren't too difficult to value -- at least in theory. However, even this requires some assumptions that may or may not prove to be valid.
Expected price of dividend stocks
One formula used to value dividend stocks is the Gordon constant growth model, which assumes that a stock's dividend will continue to grow at a constant rate:
A stock's annual dividend should be easy enough to find on any stock quote, and for the purposes of this calculation, it's fair to assume the historical dividend growth rate will continue. Required return is the biggest variable here, and is a somewhat subjective metric of the total rate of return for you to consider the stock a worthwhile investment.
For example, if I'm considering Johnson & Johnson, I can see that the company's current annual dividend is $3.00. With a little arithmetic, I can find that Johnson & Johnson has increased its dividend at an average rate of 8.6% per year over the past decade, which would make next year's dividend about $3.26. Johnson & Johnson has historically averaged a total return of about 12%, so I'll use that for the required return. Based on this information, I can calculate Johnson & Johnson's expected value as follows:
Based on these assumptions, I would expect Johnson & Johnson at $95.88, which is actually less than its current share price of about $102 as of this writing. I can interpret this as the maximum price I should pay for the stock if I expect to achieve a 12% return from my investment. So, in this case, I would consider J&J to be a bit too expensive at its current market price.
Keep in mind that the assumptions made here may or may not remain true. Over the past 10 years, J&J has increased its dividend at an average rate of 8.6%, but a slowdown is entirely possible -- especially if the current low-interest environment persists, or if another recession begins.
And, while this formula calculates the expected future price of the stock based on these variables, there is no way to predict when or if this price will actually occur. However, valuation methods like this can be useful to find dividend stocks trading for less than their intrinsic value.
For more on stocks and investing, check out our Broker Center. We'll answer your basic questions and help you choose the investing path that works best for you.
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@example.com. Thanks -- and Fool on!