What is a Dividend Growth Model?

What is a Dividend Growth Model?

Definition

The dividend growth model can be used to determine the value of a company’s stock. According to this model, a stock’s price is a function of the dividend that it pays. The dividend growth model ignores other factors that contribute to a share’s value. For example, this model does not take the market share of a company’s products into account. Neither does it give any importance to a company’s brand value.

What does dividend growth model mean?

The dividend growth model essentially values a company’s stock based on its current dividend payout and the expected payout in the future. It says that:
Stock value = D/ (k-g)
Where:
D = the dividend that the company is expected to pay in the next year.
k = this is the required rate of return that an investor needs to justify buying a particular stock.
g = the rate at which the company’s dividend is expected to grow at.

Example of dividend growth model

Steve, a stock analyst, has been given the task of calculating the value of Riverside Corporation’s stock using the dividend growth model. The relevant details for Riverside Corporation are as follows:
  • Current rate of annual dividend = $1.75 per share.
  • It is expected that the dividend will grow at 4% per year.
Additionally, the minimum rate of return that an investor would require to buy Riverside Corporation’s stock is 12%.
We can now calculate the stock’s value using the dividend growth model:
Stock value = D/ (k-g)
Stock value = $1.75/ (12%-4%)
Stock value = $21.88.
Riverside Corporation’s stock currently trades at $18. According to the dividend growth model, it should be trading at $21.88. As it is currently trading at a discount, it could be a profitable investment. Of course, this assumes the company’s dividend will grow at 4% every year.

Summary

The dividend growth model can be used to make a stock investment decision. However, this model ignores non-dividend factors and should be used in conjunction with other tools that help determine a stock’s fair value.