The most common method of valuation of stocks on the basis of dividends is often referred to as the dividend discount technique. The method is based on historical data, future expectations regarding the business of the company, the cash flows expected to be generated in the future as well as the risks of the investment. It is highly conservative and, though it is one of the oldest methods, it is still commonly used and forms an integral part of any stock valuation education or training.
The valuation is based on a mathematical formula that attempts to establish the intrinsic value or the true value of a particular stock based on the dividend yield. All the known factors are put through a process of discounting which is why this method is called the dividend discount method. As with any form of valuation, you can use this technique to determine whether the stock is undervalued [in which case you should buy], overvalued [in which case you should sell] or fully valued [in which case you should hold]. Obviously, this method of valuation cannot be used for loss making companies which would be unable to pay dividends or companies that do not pay dividends as a matter of policy and expect to reward investors through capital growth.
Basically there are four factors that you need to take into account when using the dividend discount method. You need the dividend per share, the expected rate of growth in dividends, the Beta of the stock and your expected rate of return on your investments. In many cases, the expected rate of return is calculated by identifying a risk-free rate of return [such as US treasuries] and adding to it a risk premium for the additional risk of equity investment. The Beta is simply how the stock is co-related to a standard benchmark index like the S&P 500 and establishes the volatility of the stock.
There are different methods that can be used to establish values for the input data in the formula. There are also calculation models that use two stage or multistage methods. These are used to take into account the fact that the future growth rate of a company can fluctuate over time. For instance in the early years, growth rates will be 25% to 30% but could taper off to say 5% or 6% as the company reaches maturity. The expected growth rate should take into account the rate of inflation as fun as the expected growth in GDP.
Despite the considerable daily volumes of trading in global equity markets, the average retail investor in equities is still concerned with the long-term rather than making money in the short term. As a result, the investment strategy that he or she should be following should focus on conservatism and value investing. This focus on long-term investing greatly reduces the importance of the timing of investment decisions. You should keep in mind that though the dividend discount model is conservative, it may undervalue companies with lots of intangible assets such as intellectual property and strong brands. You should also remember that your assumptions about the four factors are crucial in establishing a proper intrinsic value.
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