Are you wondering what the dividend discount model or dividend valuation model is and looking for an example? This model is a different way of valuing a company. Before buying a stock or equity, you will look at fundamentals and technicals first, but what about the future value of a company based on how many dividends they will pay out from their cash flows? This is what the dividend discount model hopes to figure out. It tries to value the stock based on the net present value of that stocks anticipated future dividends.
Dividend Discount Formula and Calculations
The formula for the dividend discount model is this:
P (Current Stock Price) equals D1 (Next years dividends) dividend by r (constant cost of equity for that company) minus g (constant growth rate in perpetuity). This is what it looks like:
r - g
This model is also called the Gordon Growth model because it was named after Myron Gordon, who originally published it in 1959.
This is definitely a model you want to consider using to value your stocks if you invest heavily in stocks that are known to pay high dividends. It’s not something you would want to use for high growth stocks that currently pay no dividends.
The reason to use this model is because valuing a company can be tricky if you do it “normally” with metrics like the P/E ratio because that does not factor in dividend payments.
If a stock you like has increase their dividends 10 percent a year for the last 20 years (but has not appreciated in price), the average person might think that this stock has underperformed the market. However, you must consider the amount of dividends the company has paid out to shareholders.
Why Dividends Are the Best
To put it simply your money makes interest every year on top of interest. Your money MAKES YOU money, each and every year, and it builds up really fast. The interest that your first investment makes starts to make interest itself. You really will leverage the power of compound interest by doing this.
The best thing you can do is start young, because then you have plenty of time to let compound interest do the work!
I personally prefer ETFs over mutual funds for a number of reasons. Mainly, if you choose an ETF that has a low expense ratio, you will save a ton of money over time in unnecessary fees. You are also spreading out your risk over a number of equities in an ETF versus owning one stock, for instance.
One example of a dividend paying ETF that I like personally is the The Global X SuperDividend ETF (SDIV) which pays 7.5 percent annually in dividends.
This dividend discount and valuation model is only one way to help you value a stock, but I think its definitely one of the more interesting and useful ways to do it!