# About Valuation of Stocks

There are many ways to value stocks- such as the use of *discounted cash flows, relative valuation as well as contingent claim valuation.*

* Did you also know that there is a simple way to value dividend stocks? And all you need is 3 steps?*

**The Dividend Discount Model** is used by many investors to value** stable** dividend stock.

The core concept of this financial model is that the **value of a stock **is the** present value of dividends to be received in the future.**

Some people also refer to it as the *Gordon Growth Model*. Myron Gordon and Eli Shapiro founded this model at the University of Toronto in 1956.

## You only need three steps to value dividend stock using the model. It is to find out:

- The
**expected dividends payout**next period **Cost of equity of the stock****Expected growth rate of dividends in perpetuity**

## Dividend Discount Model Formula

*Value of stock= Expected dividends next period/(Cost of equity-Expected growth rate of dividends in perpetuity)*

## How to Apply It

Consider Keppel DC REIT, a dividend stock that I bought. It has an *expected dividend per share for next period of $0.07. A cost of equity of 8 %, and an expected growth rate of dividend at 4% forever*. The value of this stock is:

*Value= 0.07/(.08-.04)=$1.75*

# Limitations of The Model

Dividend Discount model provides a **simple approach to value dividend stock**. But the limitation is that it is **only for firms that are growing at a stable dividend growth rate and that pays dividend.**

Since the **dividends growth rate to be inputted** is expected to **last forever**, **the earnings of the company have to grow at the same rate**. Why? *Consider a firm whose earnings grow at 3% a year forever, while its dividend grows at 6%. Over time, the dividends will exceed earnings.*

*On the other hand, if the earnings grow at a faster rate than the dividends, the dividend payout ratio will go down and converge to zero*. This is also** not an example of a company in a steady state and it will not be suitable for this model.**

As you may have noticed, this model is **sensitive to assumptions about the growth rate.**

The key is to find out what **growth rate is reasonable as a stable dividend growth rate**. Which is to be inputted into the dividend discount model. This is not an easy task.

Also, if the **growth rate of dividend is more than the cost of equity, the value calculated from the model becomes negative. ** Is this constraint logical?

Common sense says that **this constraint is logical** because a stable growth rate of dividends cannot exceed the risk-free rate. This is because as a firm grows, maintaining high growth percentage is difficult.

Eventually, the dividends growth rate will be less than the risk-free rate.

Do not forget that this growth rate is the growth rate that we assumed the dividend will grow perpetually. I think it is illogical for the growth rate to be more than the risk-free rate.

**Another limitation** is that** this model would underestimate the value of the stock that consistently pay out fewer dividends than they can afford to.**

This is because *one of the key inputs of this model is the expected dividends payout. With lesser dividend input, the value calculated would be lesser too.*

In your mind, do you already have a feel on* what kind of stocks are suitable to be calculated using this model?*

# In conclusion

This model is* ideal for firms with stable dividend growth rate.*

The **dividend growth rate has to be the one that grows at a slower rate than the risk-free rate**. Also **not forgetting a well-planned dividend payout policies that the firm’s will abide by.**

Finally, **since there are correlations between the earnings growth and the dividend growth**. *Is it possible that we substitute the dividend growth rate to earnings per share growth rate?*

Ultimately, valuation is both an art and a science. *Do you think this model is reliable? *

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**Further Reading:**