The dividend discount model (DDM) can be used to estimate fair value (net present value or NPV) for stocks. Alternatively, the DDM can be used to estimate what is the rate of return (discount rate) that the market is expecting for stock investments. To obtain the market discount rate, we replace the NPV in DDM model with the stock price P to obtain Noting that the dividend yield is Equation (2) is a simple way to evaluate the stock
investments. It tells us that the total long term return in the form of
dividends is simply the dividend yield Figure 1 shows the market discount rate for the SP500. In the plot, we have used the long term dividend growth rate of 5% and the yield is based on the historical data. The average discount rate is about 9% which matches the long term total stock market return. Lately, however, the stocks have gotten more expensive and the yield has decreased. Currently, we can expect about 7% long term returns for stock investments. Figure 1: Historical market discount rate for SP500. |