The official description of the Dividend Growth Model is; 'A stock valuation model that deals with dividends and their growth, discounted to today'.
The dividend growth model was developed by Myron Gordon, who along with Eli Shapiro in 1956, borrowing a lot of their work from John Williams, who published his book "The Theory of Investment Value" in 1938. These models have been around for quite a while and are really predicated on the idea that the reason to purchase a stock is largely centered on the purchase of future dividends. This model is also referred to as the Dividend Discount Model since much of the equation calculates and discounts future dividend payments.
This model assumes that the basis of the valuation of stock is:
- The Current Dividend
- Growth of the Dividend
- Required Rate of Return
It is best to describe this model by using an example. Assume that a stock is paying $2.00 per year in dividends, growing at 3.5% per year. The so-called variable item in this example is the investors required rate of return, which we will assume is 12.4%.
The formula for the Dividend Growth Model is:
Value = (Current Dividend * (1 + Dividend Growth)) / (Required Return - Dividend Growth)
Examples of the Dividend Growth Model
Now, let's insert the assumptions for the example into this formula to see how it works:
Value = ($2 * (1 + .035)) / (.124 - .035)
Value = $23.26
Now, what does this mean? Basically this means that based on the current situation (the assumptions) this stock should yield a 12.4% average annual return at a price of $23.26. You might want to look at the required rate of return example for a discussion of that piece of this puzzle.
The example below illustrates a flaw in this calculation. When the required rate of return of 2 stocks is very close and the dividend payments are fairly close to each other, a small variation in the required rate of return can calculate the values of 2 fairly similar stocks very differently.
Let's assume there are 2 stocks that currently pay a dividend of $1.50 per share and both stocks have a required rate of return of 7%. The first stock is growing its dividends at 5% a year and the second company at 6% a year. As you can see in the illustration below, the 2nd stock would be valued at 102% higher than the first stock because of the additional 1% per year growth in the dividend:
Stock #1 = ($1.50 * (1 + 5%)) / (7% - 5%) = $78.75/share
Stock #2 = ($1.50 * (1 + 6%)) / (7% - 6%) = $159.00/share
Dividend Growth Model Calculator