The constant stock growth model, sometimes called the Gordon model, assesses stocks using a discounted cash flow. The derivation of this model shows that current stock prices do not greatly influence future stock prices, and the primary driving force for stock movements is cash flow from dividends. By entering the expected dividends, dividend growth rate and a required return, you can determine the current stock price. Although the figure cannot accurately predict the actual value of fluctuating stock prices, it allows you to determine a target price for achieving the required return. From that, you can assess if a stock is undervalued or overvalued.
1. Call your investment broker and ask for the stock's expected annual dividend for the next term, the expected dividend growth rate and the stock's anticipated rate of return.
2. Subtract the stock's dividend growth rate from your required interest rate. For example, if the required return was 10 percent on a stock with a 6 percent dividend growth rate, you would subtract 0.06 from 0.10 to get 0.04.
3. Divide the expected dividends by this figure to calculate stock price. In the example from the previous step, if you expected the dividends to be $3 per share, you would divide that figure by 0.04. This gives you a target stock price of $75. If the current stock price is lower, then you have what is considered a bargain. If it is higher than $75, then it may be overvalued.
- cyan stock graph drawing image by .shock from Fotolia.com