There are many different ways to determine the intrinsic value of a stock. One popular method is the dividend discount model, which uses the stock's current dividend and its expected dividend growth rate to determine its theoretical current stock price. Here's how to apply this model to your own stocks, and how to use the results in your investment research.

The dividend discount model
This valuation method is passed on the theory that a company's stock price should be derived from the present value of all of its future dividends. To calculate the valuation of a stock based off its dividends, the most commonly used equation is the Gordon growth model, which looks like this:

In the equation, here's what the variables mean:

  • "P" stands for the stock's price based off its dividends. In other words, this is the theoretical valuation you're calculating.
  • "D1" stands for the stock's expected dividend over the next year. For the purposes of this calculation, you can assume that next year's dividend will grow at the company's historical rate of dividend increases.
  • "r" stands for the required rate of return. In other words, if your goal is to produce annual returns of 10% from your investments, you should use 0.10 here (10% written as a decimal).
  • "g" stands for the expected dividend growth rate. For stocks with a long history of dividend growth, you can simply use the historical average dividend growth rate. You may be able to find this on certain websites, or you can calculate it as:

For example, if a company paid a $0.10 dividend 20 years ago, and pays a $0.80 dividend now, its dividend growth rate would be $0.80/$0.10, or 8, raised to the power of 0.05. Using a calculator, you can find that this company's average historical dividend growth rate is 11%.

Re-writing the Gordon growth model formula in plain English, we have:

Keep in mind that this model is only effective when applied to stocks with a long and steady history of dividend increases -- it won't provide an effective valuation for stocks that recently started paying dividends, or stocks with erratic dividend histories.

An example
To illustrate this point, let's say I want to determine whether or not Coca-Cola is a good buy right now. The company currently pays an annual dividend of $1.32, and based on the dividend growth formula I mentioned earlier, I calculate that the company has historically increased its dividend at an average rate of 8.6% per year over the past two decades. So I can assume that next year's dividend should be in the ballpark of $1.43.

I typically shoot for annual returns in the 10-12% range on my investments, so I'll use the midpoint, or 11% for my required rate of return. Putting this all together in the Gordon growth model, I can calculate Coca-Cola's value (to me) as:

Since Coca-Cola is trading for just $42.55 as of this writing, this model tells me that it could be a good value investment at the current share price.

There are a few things to remember about this formula. For one thing, an investment's past performance doesn't guarantee its future, and that's definitely true when it comes to dividends. Just because Coca-Cola historically increased its dividend by 8.6% per year doesn't mean it will keep doing so -- especially if the current low-interest environment persists or in another recession hits.

The bottom line is that as long as you realize that this is a theoretical valuation that's based on several assumptions, it can be a useful tool for finding attractively priced stocks for your portfolio.

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