Dividend Discount Model Valuation of Coca-Cola Introduction

Valuation of companies gives a value at which each company stock costs in the market. Hence, investors are interested to know the true value of Coca-Cola stocks so that when they invest in the company, they can buy stocks at the prices that will enable them to make profits. There are many approaches to valuing companies, and the dividend discount model is one of the approaches used to value companies. The DDM is preferred over other valuation approaches because it considers dividends which are the earnings investors will realize from their investments. Additionally, the dividend discount model is more accurate than other valuation models in that it uses future dividend earnings to estimate the value an investor should pay for a stock today.

This analysis gives the value of Coca-Cola shares using the dividend discount model. The analysis also explains the assumptions made in the valuation process. Additionally, the analysis compares the intrinsic value of Coca-Cola derived from the dividend discount model with the current value of the company’s stocks to check if the model can accurately estimate the value of a company’s stocks. Incidentally, the summary section reviews the main takeaways from the analysis, and it states whether the DDM is a good valuation model or otherwise.

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Analysis

Principal Assumptions

Like other models, the dividend discount model contains assumptions that enable a valuer to forecast the value of a company’s intrinsic stock value or the real value of the company's stock (Koseoglu, 2020). The assumptions of the dividend discount model used to calculate the value of Coca-Cola Company’s intrinsic value of stocks include: the required rate of return is not equal to or less than the expected annual growth rate, increase in future dividends per share through constant dividend per share theory, Coca-Cola will continue paying dividends consistently in the future, and all investors are risk averse.

For the dividend discount model to be reliable, the required rate of return should be greater than the expected annual growth of the company's dividends. The foregoing holds because should the required rate of return be equal to the expected annual growth rate of the company's dividends, then the denominator in the dividend discount model will be zero. As such, the price of the company's stock is not defined. On the other hand, if the required rate of return is less than the expected annual growth rate, then the denominator will be negative, leading to a negative value in the price of Coca-Cola Company's stock. Generally, therefore, the assumption of non-zero and non-negativity of the denominator of the formula requires that the required rate of return must be greater than the expected annual growth rate of the company's dividends in the future.

The second assumption of the dividend discount model used to compute the intrinsic value of Coca-Cola's stock value is that the company's future dividends should increase following the constant dividend per share theory (Melicher & Norton, 2017). Coca-Cola has a constant dividend per share policy. The company pays out constant dividends regardless of fluctuations in net income. However, when the company makes high profits deemed sustainable, it increases the dividends by a margin agreed upon by the board of directors. The dividend discount policy assumes the company will maintain a consistent dividend policy. If the company changes its policy to a constant payout dividend policy, the dividend discount model will no longer be used to value its stocks. In the case of the hybrid policy (the mixture of constant annual dividend per share and constant payout ratio), the model will not still be useful to value the company’s stocks because the growth rate will be irregular.

The other assumption is that the company will continue paying dividends in the future. If the company stops paying dividends, then the value of its stock will be zero (Melicher & Norton, 2017). The model relies on dividends as earnings for investors to evaluate the present value of stocks. If the company pays dividends for some time and stops, then the dividend discount model will not be useful in evaluating its value. As such, the continuity of dividends into the future is crucial regarding the valuation of Coca-Cola stocks using the dividend discount model.

Incidentally, the model assumes that all investors seeking to invest in the company are risk averse. This assumption affects the required rate of return. Investors can invest in risk-free assets, including government bonds and bills. By investing in Coca-Cola Company's stocks, the model assumes that they have all the information they need to decide so they need in order to anticipate higher returns from the stocks than they would earn from risk-free assets (Koseoglu, 2020). In cases where investors become less risk averse, they may require a low rate of return, which may lead to the denominator of the dividend discount model being negative, hence making the value of Coca-Cola stock negative.

According to Yahoo Finance (2023), the current market value of Coca-Cola stocks is 59.86. According to the model, the stock price of Coca-Cola should be $65.55. The effect of buybacks could cause the difference. The dividend discount model considers only the stock repurchases and ignores the effect of shareholders buying the stocks again from the company. Stock buybacks will increase the prices of stocks, leading to perceptions that the stocks are overvalued. This may lead to an increase in investors' expected return rate. Another possible cause of the variation between the current value of the stock price of Coca-Cola Company and the value determined through the dividend discount model is that the growth rate of the stocks could be different from the one assumed by the model. In the future, the company may opt to increase dividends substantially for investors. In addition to increasing dividends, the company's shares are gaining or losing value, leading to strong supply-demand forces in the market. The factors mentioned above greatly impact the value of the company's shares, hence making the current market value of the stocks different from the value estimated by the dividend discount model.

Conclusion

The dividend discount model uses future dividend earnings to determine Coca-Cola's value. The model has many assumptions, including non-zero and non-negativity of the expected rate of return, the continuity of dividends into the future, and market awareness by investors. The model's stock price is different from the market price of the share because of the impact of stock buybacks and possible changes in future growth rates. The DDM is a good valuation model for valuing established companies like Coca-Cola because their dividends are stable. However, the model may not be suitable when valuing small companies with unstable dividends and disruptive companies whose dividends grow irregularly.