• Financial Statements
  • Calculating Intrinsic Value With the Dividend Growth Model

    by Joe Lan, CFA

    Valuing a stock or company is one of the most difficult tasks in investing.

    Even the most seasoned investors may shy away from the challenge for a variety of reasons. However, determining whether a stock is trading at an attractive valuation is paramount to investment success. In this installment of the Financial Statement Analysis series, I continue to review valuation metrics, specifically the dividend discount model, which is one of the many methods used to determine fair value. I also delve into some of the challenges associated with calculating “intrinsic” value using this model.

    The valuation (stock price) obtained using these formulas can vary substantially, so it is difficult to use the figures as exact buy or sell prices. However, there are several benefits that you can gain by valuing stocks yourself. It forces you, as an investor, to place a specific price on a stock that can be used as a gauge. Perhaps more importantly, valuing stocks enables you to take a deeper look at factors that drive stock price. Characteristics such as growth and fundamental elements such as income play a huge role in stock price value. You will be able to see how these metrics affect the share price determined through the dividend discount model.

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    Joe Lan, CFA is a former financial analyst for AAII.


    Discussion

    Andrew Harrell from MS posted over 2 years ago:

    Here is an idea for an follow on article. This method of valuation depends on historical growth data of the company being available for several years(as it is for those in the AAII Stock Investor Data Base). But, for an attractive looking start up growth company it probably won't be.
    Mr.Damodaran in his "Little Book of Valuation" chapter five explains how to do this. You might want to link up his method with yours and the AAII Stock Investor data base fields.

    Yours,
    Dr. Andrew Harrell
    andrewharrell@yhwhschofchrist.org


    Richard Thomas from FL posted over 2 years ago:

    Great article; however, I would like to highlight a coupe of points:

    1. You mention in the caveats section that to value a company that does not pay dividends, one should use the model presented immediately below the statement, an earnings model; however that model has the dividend payout ratio in its calculation. A company that pays no dividend would have a D/E ratio equal to zero making the stock value equal zero as well. I am presuming you meant to use just the earnings in the discount model which brings up another issue altogether. Would an equivalent model for dividend paying stocks then be (E-D)/(k-g? This earnings model would value a stock higher than the dividend discount model unless the dividend was more than 50% of earnings.

    2. Second point is regarding the required rate of return. I think what you have so eloquently described as the required rate of return is the market's required rate of return and not necessarily the investor's required rate of return. Thus calculated gives what you correctly stated as the stocks intrinsic value. However, a value investor should be looking to pay less than intrinsic value unless he is satisfied with market rates of return. For example when I use stock valuation models I use 15% expected rate of return because I am looking for a margin of safety in my purchase price as well as the opportunity to get a greater return than market rates.


    Melvin Moore from VA posted over 2 years ago:

    Does Stock Invesotr Pro compute these estimates of value and if so where are they found?


    James Grant from OH posted over 2 years ago:

    Can anyone site a an article (within AAII or outside) that presents the results of back-testing any "intrinsic" value formula over several decades that demonstrates that such a strategy at least out-performs the long term buy and hold strategy for the overall stock market?

    Or is the concept of "intrinsic" value only a good, logical one, but only theoretical and of little to no practical value?


    Doug from NY posted over 2 years ago:

    Re: Articles testing "value investing"

    Search for "value premium" at scholar.google.com. It's pretty well accepted at this point that a "value" slant can add to your returns.


    M Sharma from CA posted over 2 years ago:

    This DDM (Dividend Discount model) is a bad model. It is garbage in garbage out.
    1. Assumes a dividend in future (or next) year.
    2. Denominator is a math problem. Conceptually it does not help.
    3. Does not protect us from paying too much for growth.

    This is old school, old technology that was pushed by finance folks, MBA classes academics and even CFA curriculum. But it has so many shortcomings..ditch it.


    Vaidy Bala from AB posted over 2 years ago:

    More confused than before.Then what method to use? B.Graham and W. Buffet use value stocks, what method they use. The MS example showed the vast variation? If you are making a decision, what do you do?


    Tim Fenning from PA posted about 1 year ago:

    I feel that only using the dividend is not taking into account the retained earnings of the business. I feel that using cash flow is a better variable to use in the formula. The cash that stays on the books is an important asset for future growth. Microsoft has a huge cash balance that is totally ignored in the dividend only valuation.


    Zachariah Tripp from NH posted about 1 year ago:

    (1) These models are **VERY** sensitive to input values. If using these models, always test with slightly different values and see if there is large swings in recommend purchase price.

    (2) In my option, there are only two intrinsic values. (A) Tangible book value and (B) Enterprise Value, or more importantly, reasonable purchase price of a company to get a required rate of return. For example, if you were going to buy all of Disney and take it private all by yourself, how much would you pay for the company?

    (3) Back-test for FCF/EV: http://www.quant-investing.com/blogs/general/2015/07/21/this-outperforms-all-other-valuation-ratios-(14-year-back-test-result)

    (4) Best method I have used to date to estimate reasonable entry point (quick and easy read also with examples):

    The Warren Buffett Stock Portfolio: Warren Buffett Stock Picks: Why and When He Is Investing in Them

    http://www.amazon.com/Warren-Buffett-Stock-Portfolio-Investing/dp/1451606486/ref=sr_1_37?s=books&ie=UTF8&qid=1449803989&sr=1-37&keywords=warren+buffett


    John Zaccheo from UT posted 5 months ago:

    All ratio's are real time when applied, for comparison, it is good practice to check a Ratio at different time periods, 6mo., 1 yr. 2yrs. to see if history was accurate per the ratio's applied and the actual results, comparative to what the future might be: if HISTORICAL WITH PROPORTIONAL OR SIMILAR DATA IS GROWTH CONSISTENT, then ratio's could be a good factor to consider. Numerical data is a starting point but company management style and history with goal setting targets give you the gut factor enhanced by research and that cannot be supplemented.


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