The dividend discount model is a model that is used to evaluate stock prices. The model produces an intrinsic value that investors can use to analyze the real price of a stock to discover potentially overvalued or undervalued stocks. The basis of the model is the assumption that the value of a stock at any point in time should reflect the present value of future dividends.
1. Identify the annual dividend of a stock in dollars. For example, if a stock pays a $0.75 dividend biannually, the annual dividend is $1.50.
2. Calculate the required rate of return by adding the risk-free rate and the market risk premium. The risk-free rate is generally identified as the current rate of return on US Treasury Bills. The market risk premium is the return you expect to receive in excess of the risk-free rate. For example, if the risk-free rate is 5 percent and you expect to receive an additional 5 percent through your stock investment, the required rate of return is 0.05 + 0.05, which equals 0.10.
3. Divide the dividend by the required rate of return. In this example, the annual dividend is $1.50, and the required rate of return is .10. Therefore, the intrinsic value given by the model is $1.50/.10 or $15.
4. Compare the result with the actual price of the stock. If the stock price is lower than $15, this indicates that the stock may be undervalued. If the price is higher than $15, the stock may be overvalued.
- The dividend discount model is one of many theoretical models used to evaluate stock prices. As such, it is intended as an aid, not a definitive guide to true stock values.
Items you will need
- Dividend value
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