How to Determine the Value of a Stock Using Dividend Discount Models
How can you determine the value of a stock using dividend discount models?
United Health Care paid annual dividends of $19 per share last year, and you anticipate that future dividends will increase by 10% per annum. As a shareholder, if you require a 15% return on your investment in UHC, how much are you willing to pay to purchase one share of the stock of UHC today?
Answer:
By using the Gordon growth model in finance, one can determine that, given the provided expected future dividends and the required rate of return, one would be willing to pay $418 for one share of United Health Care today.
To determine the value of a stock using dividend discount models, you need to consider the current dividend payout and the anticipated future growth in dividends. In this case, United Health Care paid $19 per share last year and is expected to increase dividends by 10% annually.
First, calculate the expected dividend payment for the next year by multiplying the current dividend by 1 plus the growth rate: $19 x 1.1 = $20.90.
Next, determine the required rate of return, which is 15% in this scenario. Use the dividend discount model formula to calculate the present value of future dividends: Present value = Dividend payment / (Discount rate - Dividend growth rate).
Substitute the values into the formula: Present value = $20.90 / (0.15 - 0.10) = $418. Therefore, you would be willing to pay $418 to purchase one share of UHC today based on the expected future dividends and the required rate of return.
Understanding how to utilize dividend discount models in finance can help investors assess the value of a stock and make informed investment decisions. By considering factors such as dividend growth rate and required rate of return, investors can determine the appropriate price to pay for a share of a company's stock.