Welcome back to our journey of uncovering the true value of stocks! Last time, we challenged the Efficient-Market Hypothesis and embraced Warren Buffett's wisdom. Today, we're diving into the first valuation technique: The Dividend Discount Model (DDM). 📊
What it does:
The DDM calculates a stock's worth today based on the dividends you expect to receive over time. It's like a fortune teller for your investments, but instead of a crystal ball, we use a formula known as the Gordon Growth Model.
Here's how it works:
1️⃣ D is the estimated value of next year’s dividend. You can make an educated guess by looking at previous dividends and any indications from the company about future changes.
2️⃣ g is the constant growth rate for dividends. It has to be stable and realistic over the long term. Estimating g is tricky, but looking at historic growth trends and understanding the company's business can help.
3️⃣ r is the discount rate. It helps us figure out what an amount of money received in the future is worth today. One way of calculating this is the Capital Asset Pricing Model (CAPM), which considers the risk you’re taking on and how much you could make elsewhere.
Now, let's apply the model to a real-world example: Apple. 🍏
D = $0.861 (estimated next year's dividend)
r = 0.093561 (calculated using CAPM)
g = 0.03 (estimated growth rate)
Using these values, we calculate the share value as $13.55. But wait, Apple's shares are trading at $130 at the time of writing. So, what's going on?
The DDM is a powerful tool, but it's not perfect. It works best for companies where dividends are a key reason to own the stock. For many modern firms like Apple, this isn't the case. They might be buying back their shares, investing in research and development, or simply sitting on the cash.
So when should you use the DDM? 🤔
The DDM is most effective when a company has a history of paying regular dividends and is expected to continue doing so. It's particularly useful for stable and mature companies that return a significant portion of their profits to shareholders in the form of dividends. If a company doesn't pay dividends, or if its dividend pattern is irregular, other valuation methods may be more appropriate for example if they have predictable cash flow we can use Discounted cash flow model which we will talk about in our next episode.
The Dividend Discount Model is a great tool for estimating a stock’s value, but it's most effective for companies that primarily derive their value from their dividends.
Stay tuned for our next episode where we'll explore other valuation techniques for different types of companies. Until then, keep questioning, keep learning, and remember: the true value of a stock is more than just its price. #InvestingTips #DividendDiscountModel