Explaining the Dividend Discount Model

This is called the two-stage (or finite horizon) dividend discount model and looks like this:

Now that we've gotten this far, there are two important limitations to point out. First, this valuation technique, as well as any of the other discounted cash flow measures, is very sensitive to the inputs: the growth rate of the dividends (and the duration of the growth) and the discount rate used. A small change in any of these inputs has a great influence on the estimated value. Second, the dividend discount model is difficult to apply to growth businesses that do not pay dividends during periods of high growth because they can earn rates of return on investments that are above their required return.

There are a few places on the Internet that offer dividend discount models of one kind or another. Two sites that I found after a five-minute search are DividendDiscountModel.com and MoneyChimp. For a quick valuation, I typically use Bloomberg to run my dividend discount models.

Valuations

So using Bloomberg, I ran a dividend discount model for every company in the S&P 500 to determine the most overvalued and undervalued companies in the index. To do this, I kept all the assumptions that Bloomberg uses.

Obviously, this is just one measure that is typically used in conjunction with other research. In fact, it would be more appropriate to go through each name individually and determine the appropriate inputs. But in any event, here are the results of my screen:

5 Most Overvalued Stocks
Symbol	Company Name	DDM Theoretical Price	Price 11/12/03	Difference
DDS	Dillards	$0.07	$15.44	-99.5%
Q	Qwest	0.03	3.49	-99.1
PWER	Power-One	0.16	9.34	-98.3
DYN	Dynegy	0.28	3.97	-93.0
CPWR	Compuware	0.40	5.73	-92.9
Source: GNI Capital, Bloomberg

5 Most Undervalued Stocks
Symbol	Company Name	DDM Theoretical Price	Price 11/12/03	Difference
PD	Phelps Dodge	$455.44	$62.68	626.6%
NEM	Newmont Mining	205.63	43.96	367.8
ATH	Anthem	229.67	66.91	243.3
ESRX	Express Scripts	195.80	58.17	236.6
EBAY	eBay	180.44	55.50	225.1
Source: GNI Capital, Bloomberg

Using the degree of overvaluation or undervaluation of every member of the S&P 500 and the weights, you can easily determine how the S&P 500 index as a whole is valued. This methodology results in the S&P 500 being marginally undervalued by roughly 2%.

This is a pretty in-depth subject that could be covered in a semester or more of coursework. I've attempted to summarize the basic principles in one column so that you have a better sense of this common technique in security analysis.

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