David MacDougall
RTGAM






What's a stock worth? That's the hardest question analysts confront. It's also one of the most important: A target price helps investors evaluate how much they could gain by owning a company's shares.

When it comes to companies of similar size, like General Electric and Google , shares outstanding and earnings are the usually the biggest factors influencing their share prices. But those are backward-looking measures. The trick is to predict a company's future profitability. You can find clues by evaluating a company's dividends.

The dividend discount model offers a way to evaluate the present value of a company's future cash flow, a key measure of an investment. This method sets a target price by extrapolating the growth rate of a company's dividends and comparing them to the required return, the amount an investor needs to make.

Here's the formula: target price = (dividend x (1+ growth rate)) / (required return - growth rate)

It's not as difficult as it looks. For the growth rate, you can use the company's sustainable growth rate. You can set a required return by using the capital asset pricing model, or CAPM.

This method works best on established companies that are likely to pay dividends indefinitely, such as utilities. Erratic dividends lead to useless data. Let's try it on the electric companies Dominion Resources of Richmond, Va., and Atlanta-based Southern Co. . Here are the data for the firms:





Dominion

Southern


Required return

8.6%

7.6%


Dividend

1.75

1.75


Return on equity

18.8%

11.7%


Retention ratio

22%

13%


Target price

$40.61

$29.36




Southern appears overvalued at its current price of $31.26 (U.S.) by almost $1 per share, which suggests investors won't be adequately compensated by the stock at this price.

In contrast, Dominion Resources, trading at $34, appears to be a bargain with a theoretical value of $40.61. If the stock was purchased at $40.61, the investor would achieve the required return of 8.6 per cent based on these figures. Because they trade for less than that, investors could reap returns in excess of their required rates, making this a very attractive investment.

These results have played out in the market: Southern shares are down 12 per cent this year, bringing it closer to its estimated value, while Dominion shares have fallen only 2 per cent.

This model can be very touchy. The growth rate, for instance, can cause huge swings in the result, or can generate a negative number if it's larger than the required return. That's why it's best to apply this method to ordinary companies whose growth rates differ from the required returns.

This model, of course, is beholden to the necessary evil of most financial calculations: assumptions. It assumes the dividends paid this year will grow indefinitely at a certain rate. But there will be up years and down years. A company's management could cut its dividend, hold it steady or triple it.

Still, the dividend discount model takes basic data and helps investors calibrate their price expectations. While it's only one piece of the analysis puzzle, it's an important one.