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How does the dividend discount model measure up to value a stock?

by , 07 September 2015

When it comes to financial ratios, the PE (price earnings) ratio is one of the most widely used. The PE ratio gives you a way of valuing a stock in a simple way.

Companies that are growing at a slow rate or have erratic profits should trade at a low PE ratio. Whilst companies that are growing quickly should trade at a higher PE ratio.

So what about other commonly used methods such as the dividend discount model? Is it worth using?

Let's take a closer look…

What is the dividend discount model?

The dividend discount model (DDM) (also known as the Gordon growth model) is a popular way of valuing a stock.

The formula for the dividend discount model is:

P = D/(r-g)

The dividend discount model says that a share’s price (P) is equal to the value of the next year’s dividend (D), divided by the difference between the rate of the return the investor wants (r) and the long-term growth rates of the dividends (g), Cris Sholto Heaton in Money Week explains.

If a stock doesn’t pay a dividend, you can still use this method with adaptations. And if a company grows very fast for a period before settling down into a more sustainable rate, you can also still use it with adaptations.

The problems with using the dividend discount model

The problem with the dividend discount model is it’s very sensitive to changes in assumptions. And the results can be very different with small changes.

This makes the dividend discount model difficult to use as it’s extremely hard to forecast rates of growth. Using the dividend discount model in isolation isn’t a wise idea as its long-term estimates can be misleading.

You should stick to using the dividend discount model as a way of checking against other valuation methods. Just like you should with the PE ratio.

So there you have it. How the dividend discount model measures up to value a stock.

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How does the dividend discount model measure up to value a stock?
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