When looking to value stocks, investors often turn to metrics such as the price-to-earnings and price-to-book ratios. However, a company's dividend and payout policies can be equally effective valuation tools. The reason being is that the dividend offers an important glimpse into a company's ability to generate cash flow. Over the long term, companies with strong balance sheets that reward shareholders with dividends often outperform their debt-laden peers that do not pay dividends.
Dividend Discount Model
One way investors can use dividends as a way of determining a stock's value is with the dividend discount model. The dividend discount model is the stock's annual dividend per share dividend by the discount rate minus the growth rate of the dividend. "The dividend discount model can be a worthwhile tool for equity valuation. Financial theory states that the value of a stock is the worth (of) all the future cash flows expected to be generated by the firm discounted by an appropriate risk-adjusted rate. We can use dividends as a measure of the cash flows returned to the shareholder," according to research by the New York University Stern School of Business.
A critical element of income investing is dividend growth or the ability of companies to steadily raise their dividends over time. Due to the power of compounding, even a dividend that rises just 5 percent per year becomes more valuable to investors over time than a payout that stays flat. The key factor in increasing dividends is increasing profitability. "An improvement in profitability leads to an increase in stock price because investors become more optimistic about future performance of the firm," according to "The Journal of Commerce."
Just as stocks that frequently raise their dividends generate positive returns for shareholders, dividend cutters can have the opposite effect. Whether it is due to declining earnings, dwindling cash flow, rising debt or a combination of all those factors, companies that have allowed doubt to surround their dividends are often treated accordingly by the market. Inevitably, this means punishment to the stock's overall value.
A critical element to using dividends as a valuation tool is to remember that dividends tell investors what they are going to be getting in the future and it is that set of expectations that helps them value a dividend-paying stock. "The theories of stock valuation are an expression of the belief that what rational investors will pay for a stock is related to what they expect to get from the stock in the future, in terms of cash flows, and the uncertainty related to these cash flows," according to research by James Madison University.
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