Valuation Method: Accounting for Dividends with Present Value
30 June 2007As you know, I have been using 3 different valuation methods to determine a model price for a stock.
However, the one method I am still working on is the present value methodology. My concern is that it does not currently take dividends into account. And all the stocks that we analyze here at Dividends Matter pay regular, steady and increasing dividends!
For example, let’s assume that we had a theoretical stock that paid 15% every year in dividends. And let us further assume that you paid $100 for the stock today and in 10 years from now, it is still worth the exact same $100. Obviously, using my current analysis, when I discount the future stock price of $100 today at 15%, I will get a value of $24.72.
Assuming that there were no dividends, then by paying $24.72 today and having the stock price reach $100 in 10 years, I would in fact have achieved a 15% rate of return.
But this imaginary stock pays me a 15% dividend every year. So in fact, I should be willing to pay $100 for the stock today knowing that in the future, it will still be worth $100. I would still achieve my 15% rate of return.
So I am proposing the following change to the methodology. I am going to assume that the stock will continue to pay me the average high dividend yield (which would be the yield that I would initially purchase the stock at). Since I will expect to receive that dividend yield throughout the whole period, I will deduct the average high dividend yield from my 15% discount rate. That would mean that the dividend yield + my new discount rate would be equal to 15%.
And one other thing. We buy dividend paying stocks that GROW their dividends. So I should take that growth into account. I will determine a conservative future dividend growth by looking at the historical dividend growth. I will then grow the dividend by that amount for the 10 years. That means that each year, my dividend yield will grow by the dividend growth rate and consequently reduce my required 15% by a little more each year.
Does this sound reasonable? Let me know your thoughts on the issue.
For me, coming up with a model price is important in adding the discipline required to buy a stock at a fair price.
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on July 30th, 2007 at 6:05 am
[…] Valuation Method: Accounting for Dividends with Present Value @ Dividends Matter, a method of calculating a fair price for a dividend paying stock […]
on May 30th, 2008 at 4:38 pm
Hi there
This is a bit confusing. Here’s my approach. Maybe it’s the same, or maybe not?
Let’s consider a particular stock. This year the dividend was D. We expect the dividend to grown at rate R. Our discount rate is K. This represents the rate of growth we expect from a stock. We want to calculate P, the maximum price we should pay for the stock in order to achieve a return better than K.
The present value of the stock is the sum of the present value of all the future dividends.
After year 1, we get a dividend D. The present value is D.
After year 2, we get a dividend D * (1+R). The present value is D * (1+R) / (1+K)
After year 3, we get a dividend D * (1+R)^2. The present value is D * (1+R)^2 / (1+K)^2
The price P is the sum of all these present values.
This results in Gordon’s formula:
http://en.wikipedia.org/wiki/Stock_valuation
When R