Stock Investing 101

The dividend discount model is hard for novice investors to grasp and it may be a little out of date, however it can be an accurate measure of a companies worth if it is used in the right situations.

The dividend discount model attempts to evaluate the worth of a company by calculating and estimating present and future dividend payouts. It does not factor in any capital growth in the company. The equation goes like this: The expected current dividend divided by the required rate of return minus the expected growth rate of the dividend. Like I said, it is not easy to understand at first but if you are an intermediate or advanced investor looking to buy and hold a solid dividend paying company it can be another weapon in your arsenal as far as evaluating a company goes.

I would suggest that you look at these, more simple ratio’s when trying to evaluate a dividend paying company:

• The dividend yield the company is paying. This should be obvious. The average company pays out a 2% yield yearly. Look for companies paying out 3-5%.
• P/E ratio. This is price divided by earnings. If a company has a P/E ratio of less than 15 it is fairly cheap compared to what it is earning at the moment.
• PEG ratio. This is PE ratio divided by growth. The average peg ratio is a little over 1. A PEG ratio less than one means that you might have found a pretty good deal. A company trading at a 12 price to earnings ratio that is expected to grow its earnings at 12% a year in the foreseeable future is trading at a 1 PEG ratio.
• How much the dividend has appreciated over time. If a company is paying out 1 dollar a share yearly today but it paid out 1 dollar a share ten years ago then the dividend has not seen any increases in 10 years! That is not a very good sign. Look for companies that regularly increase the dividend that they pay each year, even if it is a slight increase. This means that the company is making more money and paying out more money to its shareholders each and every year which is what long term investors should be looking for.

The dividend discount model still has its merits, but it is not as valuable of an indicator as it was 30 years ago when companies put a bigger emphasis on paying out and increasing is dividend.