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The Dividend Growth Model

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  • 0:04 What Is the Dividend…
  • 1:10 The Dividend Growth…
  • 2:32 Estimate the Expected…
  • 4:02 Pros/Cons: Dividend…
  • 4:40 Lesson Summary
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Lesson Transcript
Instructor: Darlisha Oliver
The dividend growth model is used to determine the basic value of a company's stock, regardless of current industry conditions. This lesson explores the model and its use to make accurate comparisons of stock issued by companies in varied industries.

What Is the Dividend Growth Model?

The dividend growth model is the most common way investors measure the value of a company's stock. When an investor buys stock in a company, the investor becomes a shareholder by letting the company use his or her money to meet its financial needs. In return, the company pays the investor for the profits earned due to the use of the investor's funds. This payment is known as a dividend.

The dividend growth model is used to place a value on a particular stock without considering the effects of market conditions. The model also leaves out certain intangible values estimated by the company when calculating the value of the stock issued. Intangible items, such as an established brand name and customer loyalty, can increase the value of a given stock. The dividend growth model was established to place a value on a given stock without considering any of these factors.

The dividend growth model is also referred to as the dividend discount model because it gives insight on whether a particular stock is on sale. Let's take a closer look at the dividend growth model in reference to stock issued by Company X.

The Dividend Growth Model Formula

When measuring the value of a given stock, investors do not consider the brand name or customer loyalty. Instead, they use the following formula to calculate value:

Stock value = D/ (k-g)

  • D is the expected annual dividend per share for the next year
  • k is the required rate of return, which is the minimum rate an investor would require in order to purchase the stock
  • g is the dividend's expected growth rate

As an investor in the stock issued by Company X, you expect Company X to pay a $2 dividend per share next year. You also expect the dividend paid by Company X to increase by 5% each year going forward. Let's assume you require a 15% rate of return on the stock issued by Company X. The stock in Company X is currently selling for $15 per share.

Using the dividend growth model, calculate the basic value of the stock as follows: stock value = $2 / (.15 - .05), which means stock value = $2 / .10. The basic value of the stock in Company X is $20 per share. Because the stock is currently selling for $15 per share, investors can conclude that the stock is currently selling at a discount.

Estimate the Expected Growth Rate

The dividend growth model requires investors to make an assumption regarding the dividend's expected growth rate. Generally, there are three methods to estimate the expected growth rate.

First, an investor can look at the historical growth pattern of the dividend and make an assumption based on that pattern. Another way to estimate dividend growth rate is to look at the industry in which the company operates and make an assumption based on the median growth rate of dividends paid by companies in the same industry. An investor could also use the sustainable growth rate formula to estimate a company's dividend growth rate.

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