Daily Bitesize: The value today of a dividend tomorrow

'Price is what you pay. Value is what you get'-Warren Buffett

When buying a dividend paying stock it's prudent to know if you are getting value for your hard earned cash. Pay too much and it could take many years, if at all, to get your money back.

One very simple way of valuing an income stream from a dividend is the 

Dividend Discount Model DDM.

The discount rate is a measure of how highly you value your money today and is connected to the risk of the investment. The more precious your money and the higher the risk of the company/dividend then the higher the discount rate.

For example the 'risk free' discount rate would be 10-year government bond as you are certain to get your money back at the end (we'll ignore inflation at the moment!). Due to the risks associated with a companies stock the discount rate would be some percentage points above this, around 5%, give or take a few points.

TeliaSonera is a Sweden based telecommunications company, most countries have them and as is the case with these companies it pays out a high dividend of 6%, 2.85kr. It's the most owned stock by Swedes and has a pay-out ratio of around 62%, so returns a significant amount of its profits back to shareholders in the form of dividends.

We will try to value its stock price purely by its dividend and the cash flow it provides, as if it were a perpetual bond. Below is a table of valuations based on the equation above using different inputs for the discount rate and dividend growth rate.

Ignore the purple areas, that is where the calculation breaks down as the discount rate must always be higher than the growth rate (it's one of the limitations of the calculation). I've highlighted in green the combinations that closely match the current stock price of 47.8kr.

At one extreme we have TeliaSonera being evaluated by the market as having no dividend growth with a fairly low discount rate of 6%. As the growth rate increases then so can the discount rate to compensate for any extra risk.

It should be noted the Telia's dividend has grown since the lows of 2008 but is still below 2005 levels. That's a rear view analysis of the dividend and doesn't really tell us what will happen in the future.

So there you go, the share price doesn't seem extremely overvalued based on the simple dividend discount model but is a little bit too rich for my tastes. Certainly no bargain.

This valuation does assume however that the dividend will be paid out for an infinite period of time and as we all know the saying goes, 'in the long run we are all dead'!

More valuations coming in future parts.