What is the Dividend Growth Model?
Definition: The dividend growth model is an analytic strategy used to ascertain the fair value of a stock based on dividends paid out over time. The model came into being as financial advisers sough to come up with an effective way of navigating the thousands of investment options based on dividend payouts.
The dividend growth model stands out as it helps in the determination of a company’s long-term profitability. By comparing dividend growth, rate overtime investors can ascertain companies’ ability to sustain profitability over time.
Being a valuation model, the dividend growth model ascertains whether a stock is overvalued or undervalued assuming dividends payouts increase at a stable or different rate. Once a fair value of a stock is ascertained, investors can decide whether to buy or sell equities.
One of the assumptions made in the dividend growth model pertains to the rate at which dividends are expected to grow. While it is common for financial advisers to assume dividend distributions will grow at a constant rate in perpetuity, there is also a risk of the dividend growing at a variable rate.
Dividend Growth Model Formula
The dividend growth model formula for calculating the dividend growth model is:
P = D1 / ( k – g )
Whereby: P= Fair value price per share of equity
D= Expected dividend per share in one year’s time
k= expected rate of return
g= expected dividend growth rate
One of the assumptions made in the formula is that the dividend growth rate remains constant throughout. In this case, the analytic strategy assumes dividend distributions are made at a constant rate to shareholders.
Dividend Growth Model Example
Let’s assume that Company XYZ is currently trading at $10 a share backed by a quarterly dividend distribution of $0.50 a share. In this case, the expected annual dividend payout would be ($0.5 x 4= $2). If company XYZ has increased its annual dividend payout by an average of 8% over the past decades, one can assume that the trend will continue over the next decade.
Assuming the company would return not less than 24% on invested capital the fair value of the company within one year would be:
Plugging the information into the dividend growth formula
P = D1 / ( k – g )
P = 2 / ( .24 – .08 ) = $12.5
From the equation above it is clear that company XYZ share price is undervalued, with the potential of increasing in value by 25% before attaining fair value. The dividend growth model, in this case, suggests that opening a long position in company XYZ would amount to a good investment decision, given the prospects of generating an additional 25% in returns.
Dividend Growth Model Application & Analysis
While it is common for investors to conduct dividend growth analysis for one year, it is important to carry out the analysis for multiple years as a way of identifying high-quality dividend-paying equities. By carrying out the strategic analysis on multiple years, investors can have a clear idea of the amount of returns they can expect over an extended period.
Similarly, investors should evaluate additional measures as a way of generating extensive data for making informed decisions about investments. Some of the measures that investors can carry out include studying profit margin trends, earnings per share as well as sales growth.
Likewise, it is important to note that the model does not always provide accurate results on the fair value of equity. The fact that dividends rarely increase at a constant rate is one of the biggest downsides of the dividend growth model.
Similarly, it is not possible to forecast accurately growth rates a few years ahead given the varying economic cycles likely to affect a company’s performance. For this reason, calculations must be carried out repeatedly, taking into consideration the changes that take place about growth rates.
Summary
Dividend growth rate aids in the making of investment decisions by helping investors ascertain whether a stock is overvalued or undervalued. However, it should always be used with other financial metrics to make informed investment decisions.