Stock Picking strategy - Dividend Discount Model (DDM)

 Dividend Discount Model is used by investors to ascertain the today's value of the company based on the future dividends paid by the company. It is a conservative method to value stocks and hence provide high degree of reliability.

We can use this model to calculate the price at which one can buy the stock in order to acheive his/her desired rate of return.
Lets take NIIT Technologies to understand this Model.

CMP Of NIIT Technologies as on 23 May 2011 - Rs. 186.
FY-11 EPS - Rs. 30.7
FY-11 recommended dividend - Rs 7.5
FY-10 dividend - Rs 7.0
FY-11 PE = 186/30.7 = 6.05

Considering the Company's past growth and performance let's assume that the company will be able to deliver a revenue and profit growth of mnimum 10% for next three years. Also the company will payout 25% dividend every year. Based on this follwoing are the expected EPS and dividend per share for next three years.

FY-12 Expected EPS = Rs. 33.7
FY-12 Expected Dividend = Rs. 8

FY-13 Expected EPS = Rs. 37
FY-13 Expected Dividend = Rs. 9

FY-14 Expected EPS = Rs. 41.
FY-14 Expected Dividend = Rs. 10

Also let's assume a conservative PE multiple of 8 for FY-14 which is on the lower side that the company of this size and business commands. So based on the expected EPS of 41 for FY 14 the target price would be
41*8 = Rs. 328

Now say the Investor's required compounded rate of return is 25% in next three years.

If you invest in NIIT Technology today then you would receive dividend for the current year without waithing for 1 year. So your dividend income in three years looks like this:
first year = 7.5 + 8 = 15.5
2nd year = 9
3rd year = 10

The DDM formula is

Price = Div1/(1+r) + Div2/ (1+r)(1+r) + Div3/(1+r)(1+r)(1+r) + --------- + Terminal price/(1+r)(1+r)(1+r)(1+r)...

So the expected price for NIIT Tech to get your desired return is

Price = 15.5/1.25 + 9/(1.25)(1.25) + 10/(1.25)(1.25)(1.25) + 328/(1.25)(1.25)(1.25)
= 12.40 + 5.76 + 5.12 + 167.9 = 191

So if you buy NIIT tech at Rs. 191 there is reasonable chance that you might make 25% annual return for next three years.

Now since NIIT tech is currently trading at Rs 186 it gives reasonable margin of safety from deviations that might happen between the assumption and actual result in future.

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