Stock-picking: Using DDM

How do you figure out what stock price represents its real, true worth?

I like to use this column to introduce you to things that you really don’t see in a lot of other places. Today our adventure is to look into a little technique that some analysts use to decide whether a stock is overpriced, underpriced, or is priced just right. From here on in, you’ll be able to use it too.

Let me paint some background. You’ve been watching a stock for the past year, which is currently trading at $10 per share. It’s been as high as $15, and as low as $5. You’re wondering whether $10 is a fair price to pay for the stock, whether in fact it’s worth $15 per share (in which case $10 is a steal) or whether it’s only worth $5, and therefore at $10 it’s way overpriced. How do you decide what the ‘correct’ price is?

Here’s a second scenario. An analyst at a major brokerage firm has just reiterated a buy recommendation on a stock that is trading at $83 per share. As part of her recommendation, she includes a one-year price target of $92 per share. You wonder how she decided that $83 was a cheap enough price to make the shares a buy. And you especially wonder how she came to believe that the stock will be trading at $92 one year from now.

Both cases point to the necessity of knowing the ‘true’ or ‘economic’ value of the shares in question. If the ‘true’ or ‘economic’ value of the shares is, say, $12 and they’re trading in the market at $10, the shares are a buy. If they’re trading at $14, though, or $20 or $72 or $100, they’re not. It’s as simple as that.

Happily, determining the true or economic value of a share is quite easy, at least for dividend-paying stocks. There’s a simple formula called the dividend discount model that will give you the economic value of a share in dollars and cents. All you have to do is take the current dividend per share, and divide it by the difference between your required rate of return and the company’s growth rate. Let’s try a simple example.

Remember that stock that is trading at $10 per share, and had been as low as $5 and as high as $15? Suppose that stock pays an annual dividend per share of $0.38. Suppose also that your required rate of return (explained later) on that stock is 7%, and that for the past number of years the company has been growing about 4.2% per year (also explained later). What is that stock’s true or economic value?

First, find the difference between the required rate and the company’s growth rate. In decimal terms that’s 0.070 minus 0.042 equals 0.028. Now take the $0.38 annual dividend and divide it by 0.028. Bingo, the true economic value of that common share is $13.57. Since it’s currently trading at only $10 per share, you would consider it a buy.

There are three key figures you need to employ this model. First, you need to know the indicated annual dividend per share. That’s easy to find on any quote service. Your required rate of return is also important in determining the final price, and it takes time for each person to learn what their particular rate is. It’s the sum of long-term real rates of return, a current inflation supplement, and your own personal risk premium. But what you can do for starters is to just use a standard 7% for each and every stock you run through the model.

Finally, you also need to know the company’s recent growth rate. For that you can take an average of its last five or seven years’ return on equity, and multiply that average by a factor of one minus the company’s dividend payout ratio. If, for example, the company’s average ROE over the past five years was 7%, and its average dividend payout ratio over the same time frame was 40%, the company’s growth rate would be 0.07 times (1 – 0.40) which equals 0.042 or 4.2%. That’s the same growth rate we used in the example above.

This basic dividend discount model, or DDM, is not perfect in many ways. But it is easy to use, and using it is better than not using it. Why not try it out on some of the stocks you follow, and see what it says?