Valuing Stocks: The DDM Way

This generic truism can be applied to every tangible or intangible thing we can imagine. However, it can't be more apt than in the valuing of Shares. As common retail investors, we buy shares at a price which we seem to agree with on various technical levels and also because our relative or broker said so. But, rarely do we realize what its true value is.

Now, the basic essence of valuing any financial asset is, that it's price today, should reflect all the future benefits one shall derive from it. So if a company's expected to give a once and for all, Rs. 100 to each Shareholder at the end of the year, then today, the Share price should not be anything other than Rs. 90.10 if the prevailing interest rate in the market is 10%. If the price is any different, a whole lot of money can be made through arbitrage.

The benefits derived from a share can be divided into two categories. Total returns in a share would primarily comprise of Dividend Income and Capital Gains. So, a stock that gives a consistent and a stable dividend each year can be valued using the same Present value of all future benefits principle, in a manner, somewhat similar to what we just saw above.

The three major inputs of this model are the next year's dividend, the required rate of return and future growth rate. Each of the aforementioned can be calculated and estimated using underlying assumptions and given current facts.

While I shall spare you the mathematical details and progression formulae, the basic idea is to calculate the price today; based on all the future dividends that company is expected to give discounting it by the required rate of return minus expected dividend growth rate. There are various analyst reports and tools available online that value stocks using the DDM (Dividend Discount Model). As common investors, we must just look at them and decide for ourselves rather than relying on random recommendations.

However, it's important to have a holistic picture of where this model works and where it may be totally futile. Half knowledge can be dangerous, and in this case, can be very expensive. So the Dividend Discount Model works only with companies that pay a stable dividend. That rules out most companies that don't pay dividends or give dividends sporadically. There are a few obvious flaws in this valuation method, but by and large it is a good starting point for determining share prices, as it's basic premise is sound.

at 9:34 PM
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