09-02-2013, 09:01 AM
I have done a lot a thinking about valuation. A good book on the topic is The Little Book of Valuation. I think the best technique for valuing dividend stocks is the perpetuity. All the other techniques are either too sensitive or too rigid. For example, the Gordon Growth model is unstable.
Not only is the perpetuity method stable, but it allows comparison with the corporate bond rate, which is the main competitor to dividend stocks. I use the Bloomberg Investment Grade Bond Index for the corporate bond rate.
The perpetuity method divides an expected return by a discount rate. For the expected return, I use the annual dividend and discount it for the debt per share. The philosophy is that when you buy a share you also take on the debt, so the stock price must be less to compensate.
Expected Return = Dividend x Price/(Price + Debt Per Share)
Bonds must compensate for inflation in their rates; however, the stock price is assumed to rise with inflation, so the expected rate of return is the difference.
Discount Rate = Corporate Bond Rate - Inflation Rate
Similarly, the dividend growth can included by averaging the current and assumed future dividend over a number of years.
I use the current dividend valuation as a screen, while I use the price relative to the future dividend valuation as the primary factor in selecting between stocks.
Not only is the perpetuity method stable, but it allows comparison with the corporate bond rate, which is the main competitor to dividend stocks. I use the Bloomberg Investment Grade Bond Index for the corporate bond rate.
The perpetuity method divides an expected return by a discount rate. For the expected return, I use the annual dividend and discount it for the debt per share. The philosophy is that when you buy a share you also take on the debt, so the stock price must be less to compensate.
Expected Return = Dividend x Price/(Price + Debt Per Share)
Bonds must compensate for inflation in their rates; however, the stock price is assumed to rise with inflation, so the expected rate of return is the difference.
Discount Rate = Corporate Bond Rate - Inflation Rate
Similarly, the dividend growth can included by averaging the current and assumed future dividend over a number of years.
I use the current dividend valuation as a screen, while I use the price relative to the future dividend valuation as the primary factor in selecting between stocks.