The result is the earnings discount model's P/E, which can then be compared to the market's P/E. Take the payout ratio (the current dividend divided by the current earnings per share) and divide that by the difference between the investor's discount rate and the dividend growth rate. The earnings discount model addresses that by factoring in payout ratio, or the proportion of earnings devoted to dividend payments. Traditional dividend discount calculations do not consider any broader views of company performance or management policy in their evaluation. Keep in mind that dividend scenarios other than indefinite stability or indefinite growth at a steady rate would require more complex computations. Given the baseline values indicated previously, the present value of the dividend stream in the second scenario would be $50 ($2/(7% − 3%)). If a company were expected to grow its dividend by a constant rate indefinitely, then the present value would be the current dividend amount divided by the difference between the discount rate and the expected growth rate (this only works arithmetically when the expected growth rate is less than the dividend rate). For example, a stock that is expected to pay a $2 annual dividend in a market environment that supports a 7% discount rate would have a present value for its dividend stream of $28.57. If the company currently pays a dividend and you assume that the dividend will remain constant indefinitely, then the present value of the dividend would simply be dividend dollar amount divided by the desired discount rate. The dividend discount model (DDM) is a method for assessing the present value of a stock based on its dividend rate. Practical applications of theory The dividend discount model The larger the discount rate is, the bigger the reduction from future value to present value will be. However, as the net variability in any expected performance dimension increases, so does the investor's desired risk premium, increasing the discount rate in that dimension. They tend to require a relatively small excess charge over the risk-free base rate used in discounting models, so they are said to have a relatively small risk premium. Companies with historically stable earnings, dividends, or free cash flow combined with stable outlooks for future performance may be seen as being relatively low risk in those dimensions. The risk of nonpayment is the other major factor in determining a discount rate and it tends to be more difficult to assess. In markets with unstable sovereign debt, there may be no functional surrogate rate in the local currency that could be called risk free, making this type of analysis more complex. In mature markets other than the United States, investors typically use that market's short-term sovereign debt as the applicable risk-free benchmark. However, in practice, the prevailing interest rate on short-term notes issued by the US Treasury is often used as an approximation since these securities are widely believed to have negligible credit and redemption risks. Admittedly, a truly risk-free investment exists only in theory. The baseline cost in discounting is typically an opportunity cost specifically, it is the income the investor foregoes by not putting the same value into a risk-free investment. A related figure, net present value (NPV), factors in direct costs incurred by the investor to realize the cash flows, such as the foreseeable taxes due on dividend payments or additional capital inputs that might be required by future calls. That value is known generically as present value (PV). Thus, a series of payments into the future is not merely the sum of those payments, but a transformation of that series into a single number that represents the present-day equivalent value of the cash flow. Through that lens, a stock investment can be looked at as some combination of earnings, cash flow, or dividend streams, plus the potential increase in share value that could be realized by the eventual liquidation of the investment.Īt the base of the valuation process is the concept of financial discounting-the idea that a payment deferred into the future should be worth more than a payment made today in order to compensate the recipient for the costs and risks inherent in waiting. Financial theory posits that the value of an investment can be seen as the sum of the future cash flows the investment is expected to produce.
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