The dividend discount model and other discounted cash flow approached define the value of a stock as a function of the current cash flow, growth and a required rate of return. Normally these models are used to derive a valuation, which is then compared to the current stock price to determine whether the stock is “overvalued” or “undervalued.” The determination will be affected by the assumptions made regarding required return and growth.
An alternative is to reverse the model and use the current stock price to determine the average assumptions being implicitly made by investors. For example, consider a stock with a current share price of $20.00 and an expected annual dividend of $1.00 per share. An investor who calculates the required return (perhaps using the Capital Asset Pricing Model) as 10% can calculate the growth rate implied by the current valuation.
The Gordon growth model says Value = D1/(r-g).Â Substituting what is known, we get $20.00 = $1.00/(0.1- g). We can then solve for g and get an implied growth rate of 0.05, or 5%.
Many investors find it more intuitive to evaluate whether the market as a whole is making realistic assumptions regarding growth than to develop a possibly complicated and error-prone procedure for estimating the growth itself.For more information, see all articles on: Investing in Stocks, Investment Returns, Valuation See also: