Anyone Taking The CFA Should Understand This Complicated Formula About Valuing Dividends

How do you value a stock?

Well, there are many ways. And every method and model has its strengths and weaknesses.

One of the very first models that any entry-level analyst will learn is the dividend discount model (DDM). And for anyone taking the grueling Chartered Financial Analyst (CFA) exams on June 1, the DDM is one of the most basic valuation models to master.

The concept is straightforward: the value of a stock is equal to the present value of all of the future dividends it pays.

The DDM has limitations (which we'll address later). But it is theoretically sound, and people like it because it's relatively simple and clear.

The basic DDM model has four variables: the price of the stock (P), the dividend (D), a growth rate (g), and a discount rate (k). One form of the DDM will look something like this:

The primary aim of asset valuation is arguably to find the value of that stock. But if you have the market price of the stock, you can use the DDM to find the implied values of those other three variables.

That's what Goldman Sachs did recently in their new US Monthly Chartbook. They used the market price of a stock, its dividend, and a discount rate (as measured by its cost of equity) to derive the implied value of the last variable: the growth rate. (Goldman had a reason for deriving implied growth, but it's not important for our purposes).

Here's Goldman's explanatory slide, which it included in its Chartbook for clients. For most, this is intimidating. But any analyst who passed the first two levels of the CFA exam should have no trouble navigating through it.

Limitations

Like we said earlier, the DDM has limitations. The most obvious limitation: it doesn't work for companies that don't pay dividends.

Assuming the company pays a dividend, you have to know what the dividends will be in the future. And anyone who was holding a dividend-paying bank stock during the financial crisis knows that a steady quarterly cash dividend will quickly get slashed when profits collapse.

Furthermore, the DDM is very sensitive to the growth rate (g) and the discount rate (k) assumptions.

So, while the model is sound, it's garbage in, garbage out.