Question

In practice, what is a common way to value a share of stock when a company pays dividends?

1) Discounted Cash Flow (DCF) analysis
2) Price-to-Earnings (P/E) ratio
3) Dividend Discount Model (DDM)
4) Return on Investment (ROI)

Answer 1

The Dividend Discount Model (DDM) is a common method used to value a share of a stock for a company that pays dividends, based on the concept of Present Discounted Value (PDV).

Step-by-step explanation:

In practice, when valuing a share of stock for a company that pays dividends, a common method is the Dividend Discount Model (DDM). This model is based on the concept of Present Discounted Value (PDV), where future dividend payments are discounted back to their present value.

To use DDM, one must estimate future dividends and discount them at an appropriate rate that reflects the risk of the investment.

An example of applying the PDV to a stock can be illustrated with Babble, Inc., a hypothetical company that projects profits (and therefore dividends) of $15 million immediately, $20 million one year from now, and $25 million in two years.

If these profits were to be paid out as dividends and discounted at an interest rate, an investor could determine the maximum price they should be willing to pay for a share of Babble, Inc. today.