How to Determine the Valuation Based on the Dividends
Company value can be determined through dividend calculations. The dividend discount model can be a useful tool to value equity. It values a stock or a company based on future cash flows discounted by risk-adjusted rates. The dividends serve as an indicator of those cash flows. However, this model is highly reliant on its assumptions and should therefore be used in conjunction with other valuation methods. Extra care should be taken in interpreting source data.
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Instructions
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Get to know the basic equation. The basic model is the formula first developed by John Burr Williams in 1938 to calculate the value of common stock by discounting the future stream of dividends. It can be expressed through the formula: Value equals current dividends “D” divided by expected interest rate “I” less projected growth rate “G” (Value = D / (I – G)). There are several different dividend models, but most are based on Williams’ concept.
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Set your interest rate expectations. Source inputs like current dividends of a company can be found on business sites such as CNBC.com. However, the expected interest rate (I) is an assumption. Select a realistic interest rate you’d like to receive considering market alternatives. For example, you may choose 9 percent for a company’s common stocks if its less-risky corporate bonds are yielding 6 percent. Compare your assumption with other well-established industry-peer stocks.
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Choose the projected growth rate. Use market indices such as the S&P 500 as benchmarks for appropriate growth rates. Look for global trends in growth or decline. Additionally, use a sector-specific index like the Dow Jones U.S. Internet Index, if analyzing technology companies to dial in the growth rate among its peers.
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Combine the inputs and calculate. Enter your assumptions and source data into the basic equation. As an example, if the current dividend (D) is $10 per share; the expected interest rate (I) is 9 percent; and the projected growth rate (G) is 3 percent, then $10 / (.09 - .03) = $166.67.
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Calculate the difference between the bond and stock yield. Take the current dividends (D) of $10 and divide them by the value of $166.67 to arrive at the yield on stock of 5.99 percent ($10.00 / $166.67 = 0.0599). For illustration purposes, if the yield on the company’s bond was 6 percent and on equity is 5.99 percent, this means they have very similar values. The smaller the difference between an investor’s target return and dividend growth, the greater the stock value, according to Williams’ formula.
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Tips & Warnings
Investigate past dividend-paying histories of the company in question and its peers for data accuracy.
Remember that the dividend discount model should be used in tandem with other valuation methods because the model is far from perfect. For instance, the basic model assumes a constant projected growth rate forever, which is highly inaccurate.
Don’t forget that this model is highly subjective and susceptible to its source data. Therefore, if the fundamental assumptions are faulty, the valuation will be as well.
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