to as “discounted cash flow.” Our goal is to calculate the “present value” of
the cash we expect to receive from our share ownership.
To understand the concept of present value, consider the intuitively
obvious fact that receipt of $1,000 today is not the same as receiving
$1,000 a year from now. This would be so even if we could be completely
certain the obligation would be honored a year hence. If one-year interest
rates are 5 percent, we could invest $1,000 today and have $1,050 one
year hence. If we start with $952.38 today and invest it at 5 percent, we’ll
have $1,000 at the end of a year. Hence $952.38 is the present value of
$1,000 assuming a one-year time frame and a 5 percent “discount” rate. If
we assume a two-year waiting period, the present value of $1,000 would
drop to $907.03. That’s the amount we’d have to start with if we want to
have $1,000 after investing for two years at a 5 percent compound annual
interest rate.
Mathematical models have been developed to calculate fair prices for
fixed income securities based on the present value of each interest payment
and the present value of the debt principal that gets repaid at some
point in the future. Stocks are similar in that we can look at the present
values of expected dividend payments. But stocks have no maturity date.
The closest we can come to principal repayment is the present value of
proceeds we expect to receive when we sell the shares later on. But in
contrast to the situation with debt (fixed income securities such as bonds),
stock resale proceeds are not usually fixed by contract. Instead, the price
is based on the present values of dividends and eventual stock sale proceeds
the future buyer will expect to receive. Another complication lies in
the fact that dividend payments, unlike bond interest, are expected to
grow over time.
The classic approach to addressing such issues is known as the Gordon
Dividend Discount Model (DDM). It values stocks based on a simple
formula:
P = D/(R – G)
where P = stock price
D = dividend
R = required rate of annual return
G = projected dividend growth rate
The calculation itself can easily be done using inexpensive handheld
calculators. That, in and of itself, is a red flag. To borrow an oft-used investment
cliché, if it were really that easy, we’d all be rich. But we’re not.
So it can’t really be as easy as it looks. Indeed, it’s not, as we’ll see.
Read More : The Dividend Discount Model
