Dividend Discount Model - Essay Example

Understanding the time value of money is of utmost importance to investing. Time value of money is a series of concepts that allows you to compare different options: Is it better to receive $40,000 today or $50,000 one year from today? If you understand the concept of discounted values, you can easily perform a calculation and come up with the right decision.

The DDM model is based on the basic valuation technique and discounting principle. It combines the time value of money and future discounted cash flows considering the time preference and rationality of the investors.

Therefore, Stock Price = D / r
so, to calculate the price of Stock ABC, we plug in the numbers to get:-
Stock Price = $3 / (0.05) = $60

This method indicates to you that if you buy at $60, the $3 annual dividend will ensure you receive a 5% return on your investment. If Stock ABC is trading below $60 right now, it's a buy. If it's trading above $60, we should wait for the price to come down.

Considering/Factoring in Dividend Growth

 Considering, if Stock XYZ has the probability to grow its dividend? This isn't an unreasonable assumption at all. As long as a company can grow its margins, it should be able to grow its dividend. Let's assume we think Company ABC can grow its dividend by 2% every year.
Adding this growth assumption gives us the "reduced form DDM" with the following formula:-

Stock Price = D1 / (r - g)
where,
D1 = the dividend at year 1                 g = the dividend growth rate
To calculate the dividend at year 1, all we need to do is multiply the current dividend ($3) by the dividend growth rate (2%): D1 = $3* (1 + 0.02) = $3.06. Now we can plug it into the formula with the rest of our assumptions: -
Stock Price = $3.06 / (0.05 - 0.02) = $102
Therefore,

How much more valuable Stock XYZ comes if it can realistically grow dividends by 2% per year ($102 vs. $60).

The rationale of selling or keeping the dividend is based on the future value of money and discounted values.

PRICE RATIOS

The P/E ratio is the rock star of valuation ratios and gets most of the attention. The P/E ratio is popular because it’s easy to understand. Imagine a stock price is $30 a share, and the company earned $1.50 a share. That means investors are paying a price that’s 20 times higher than the company’s earnings. If the price of earnings, or P/E, is high, it means that the earnings are very valuable to other people, usually because they expect the company to grow rapidly.

The rationale of selling or keeping the dividend is based on the future value of money and discounted values.