Paychex, Inc. (Nasdaq: PAYX) currently pays a dividend yield of 3.2% which is above the Information Technology sector median of 1.7%. While this makes the total return potential for Paychex attractive, investors may change their mind when analyzing the company’s future dividends. In this article, I calculate Paychex’s fair value by forecasting its dividend distributions and discounting them back to today’s value.

Valuation Methodologies Are Not Made Equally

The Dividend Discount Model (DDM) estimates the value of a company’s stock price based on the theory that its worth is equal to the sum of the present value of its future dividend payments to shareholders.

But before discussing the assumptions used in my dividend discount model for Paychex, it’s first helpful to determine if this is actually an appropriate technique to be used when estimating its fair value. Many analysts find it difficult when trying to figure out the correct valuation methodology for a given company or are biased towards one specific approach. This is often a mistake which can negatively impact investment decisions and result in trading losses or missed opportunities. No two companies are the same and every business consists of unique characteristics that may require you to adjust your analysis.

Understanding leverage trends is the first step when determining what valuation analyses are relevant for a given company. When a company’s leverage doesn’t fluctuate or is expected to remain stable over time, then an equity valuation model (e.g. equity DCF, DDM) will be the most appropriate valuation technique. The reason for this is because when leverage is stable, interest expense on debt can typically be projected with much more reliability.

How do we check if a company’s leverage has been fluctuating or is expected to do so? This isn’t always straightforward but checking debt ratio trends over the last three to five years can be a good indicator. Paychex has historically carried no debt on its balance sheet suggesting an equity valuation model is a suitable technique. Now does it make sense to use a dividend discount model knowing that an equity valuation technique is an appropriate methodology?