Explaining the Dividend Discount Model

This column was originally published on RealMoney. It's being republished as a bonus for TheStreet.com readers.

In my recent column on pairs trading, I mentioned using the dividend discount model as a method of valuing a company. I got several emails from readers who had never heard of the dividend discount model or how it is used, so here's an explanation of this commonly used valuation technique.

If you've ever taken an introductory finance or accounting course, you'll recall that the value of an asset is the present value of the expected future cash flows from that asset, discounted at a rate appropriate to the level of risk of the cash flows. Analysts can use a number of different "cash flows" to determine an asset's worth, including dividends, operating cash flow or free cash flow to equity.

When valuing a stock, dividends are the most clear-cut way of defining cash flows; they're actual cash flows that go directly to the investor. Therefore, while the discounted cash flow valuation methods are important, we'll focus here on the dividend discount model, which is the basic and most common method of valuing equity.

Assessing the Inputs

In the simplest form of the dividend discount model, there are only three required inputs: the expected dividend, the dividend growth rate and the equity discount rate. To determine the expected dividends, you must make certain assumptions about future earnings and payout ratios. In order to keep this uncomplicated, let's assume that dividends infinitely grow at a constant rate.

So what rate do we use to determine the discounted present value of these cash flows? This equity discount rate is also sometimes called the required return, or the cost of equity. You can determine this rate in a number of different ways -- nothing is ever easy, is it? -- but to simplify things for this column, I'll share one common method, called the capital asset pricing model approach.