Dividend Discount Method Valuation

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Definition

This valuation method determines an approximate valuation based on the expected future dividend payments and sale price of a stock over the next five years.

The formula can be read as follows:

Start by looking at just one term of the equation: D1/(1+r). Here is what it represents: D1 is the dividend that the stock will pay in year 1, at its future value in year 1. However, since money received in the future is worth less than money received today, we need to bring the value D1 back to its present value. To do this, we divide by (1+r), or one plus the required rate of return on our investment. Then, the value D1/(1+r) is the present value of the dividend that will be paid to us one year from now. Similarly, D2/(1+r)^2 is the present value of the dividend that will be paid to us two years from now, D3/(1+r)^3 is the present value of the dividend that will be paid three years from now, and so on.

In year 5, we assume not only that we are paid a dividend, but also that we liquidate (or sell) our holdings. The price that we will obtain is PE x EPS5, or the PE ratio in year 5 times the earnings per share in year 5. We should mention that when selling in year 5, we will almost never sell for PE x EPS5 exactly.

Then, once we have PE x EPS5, we discount that price to the present value by dividing by (1+r)^5.

Putting all of this together, the present value of the stock is equal to the present value of future dividends plus the present value of the future selling price of the stock.

Formula

Value = D1/(1+r) + D2/(1+r)^2 + D3/(1+r)^3 + D4/(1+r)^4 + D5/(1+r)^5 + (PE x EPS5)/(1+r)^5

Where:

PE = The expected PE ratio in year 5 (see PE Valuation Method for how to calculate)
Dt = EPS_TTM x (1+g)^t x b = The dividend in year t
EPS5 = EPS_TTM x (1+g)^5 = Estimated EPS five years from now

Where:
EPS_TTM = Trailing twelve months earnings per share
g = The 5 year expected earnings growth rate
b = Dividend/(Net Income) = The dividend payout ratio (calculated using the average payout from the last 5 years)

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