One of the most important part of dividend growth investing is to choose which stock you will invest in next. There are many ‘raw’ indicators that can help you with this process, for example the current dividend yield, the annual growth of the dividend, and several others.
However, there is more you can do than just looking at raw indicators. There are mathematical models that have been specifically developed to determine the value of a given stock for a dividend growth investor. We are going to see one of those models in this article, called the Dividend Discount Model (DDM). We are going to see how it can help you make better investment decisions.
What is the Dividend Discount Model?
The dividend discount model is a mathematical model that was made to help the dividend growth investor estimate the value of a dividend growth stock, based on an expected return in the future. It basically predicts what the current value of the stock should be, based on the current dividend, the dividend growth rate, and also the expected return rate for the investor.
Therefore, if the value you get from the model is inferior to the current value of the stock on the market, it means that the stock is currently overvalued. If the value from the model is superior, it means that the stock is probably undervalued at the moment.
Why You Should Use it For Your Decisions
I always say here and on my podcast/videos that there is no single ‘magic’ number that can lead you to decide on a given investment. However, using models like the DDM can really help you with your investment decisions, as it adds another criteria to filters stocks.
Indeed, the number that you get from this model can really quickly help you decide if the stock you are considering investing in is overvalued or undervalued. I for example use it now in all my investment decisions, to quickly rule out all the stocks that are currently way too overvalued on the market.
How to Use the Dividend Discount Model
Let’s now see how to actually calculate the price given by the Dividend Discount Model. The stock price using this model is given by:
Stock Price = D0 * (1 + g) / (r – g)
Let’s explain all the terms inside this equation. D0 is the current annual dividend distributed by the company. The factor g here is the annual dividend growth rate. What I recommend is to take the average growth rate over several years. Finally, the parameter r is the return you are expecting from the stock. This can be estimated by several parameters coming from the stock market, but ultimately represents what you expect from the stock market. I will set it to 5% for the rest of this article, for the sake of the calculations.
To finish this article, we are going to see some examples using stocks that I currently have in my portfolio. Note that those numbers are only valid when this article was written, so please do your own calculations if you are reading this far in the future.
For Johnson & Johnson for example, the current price of the stock is around $113, whereas the DDM gives us a current value of $82, which is much lower than the actual value of the stock on the market. Therefore, this great company is currently consider as overvalued using the DDM.
For IBM, things are different: the price of the stock is currently around $147, whereas the value given by the DDM is $244. This is a good example of an undervalued dividend growth stocks at the moment.
For Procter & Gamble, things are more complicated: the price of the stock is currently around $81, and the DDM value is at $72. Therefore, the DDM won’t be of such a great help as the two values are close, meaning the stock is correctly valued at the moment according to the DDM.
Also note that the tool that I created to quickly browse dividend-paying stocks and ETFs, DividendStocks.io, is also currently integrating the Dividend Discount Model, which is automatically calculated for you!
Are you using the Dividend Discount Model for your investment decisions? Let me know in the comments below!