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The dividend discount model is a way of applying net present value analysis to estimate the future dividends a stock will pay. Those dividends are then discounted back to their present value.  If the present value of the future dividends is more than the current market value of the stock, the stock is said to be undervalued.  If the present value is more, then the stock is overvalued.

Present Value of Future Dividends = Dividends Per Share / (Discount Rate – Dividend Growth Rate)

The discount rate equals the rate investors require for their investment.

The dividend discount model has its limitations.  For one, since a company's dividends are discretionary, they are very difficult to predict. In addition, it’s difficult to predict their growth rate.  Finally, the model is not suitable for a company that doesn’t pay dividends.

Assume Divco stock trades at $25.  Charlie thinks it is a good investment but wants to be sure that he’ll receive a 12% return on his investments.  His research reveals Divco pays a $3 annual dividend that is expected to grow by 4% annually.  Using those numbers in the dividend discount model, the present value of the future Divco dividends is $37.50

$3/(.12-.04) = $37.50

Since the present value of the future dividends is greater than the current stock price, Divco is undervalued by the market and a good investment for Charlie based on the dividend discount model. 

 

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