Dividend Definitions – What is the Dividend Growth Model?

The dividend growth model is used to estimate the share-price value of a dividend-paying equity.

Investors can use this estimated fair value of a particular stock as one of the components in their investment selection process. An equity whose current actual share price is lower than the fair value estimated by the dividend growth model could be an investment opportunity.

Alternatively, a stock might be overvalued if its current price is above the estimated fair values. If so, shareholders should consider selling that position. It is important to note that investors should refrain from making these decisions lightly and use further analysis of other financial metrics and indicators.

Dividend Growth Formula

While the term Dividend Growth Model might intimidate some investors, the model’s formula is quite simple and requires only three inputs. Additionally, all thee inputs necessary for the calculation – the expected total dividend per share over the next year, the expected dividend growth rate and the investor’s required rate of return – are simple and readily available. While these inputs are indeed simple and easy to find, two of them – the anticipated dividend payout and the dividend growth rate – are based on assumptions about future performance. The third input – the required rate of return – can be highly subjective.

However, once investors gather realistic inputs, the dividend growth model formula is:

Where:

P = A stock’s fair value price per share

D₁ = Total dividend distribution per share expected over the next 12 months

g = Expected dividend growth rate over the next 12 months

k = Investor’s required rate of return

For investors looking at a one-year time frame, this simple formula is sufficient to evaluate quickly whether an equity might be able to meet the desirable return over the short-term horizon.

Example 1a: Baseline

Verizon Communications, Inc. (NYSE:VZ) has raised its dividend payout amount 2.2% per year over the past several years. Additionally, the company just hiked its quarterly dividend amount from $0.59 paid for all four periods in 2018 to the $0.6025 distribution amount for the next scheduled pay date on February 1, 2019. Assuming that the company will pay the same quarterly distribution amount in all four periods of 2019 as it did in 2018, we can extrapolate the total expected annual dividend payout for the upcoming year.

Total annual dividend = Dividend per period x number of periods

Total annual dividend = $0.6025 x 4

Total annual dividend = $2.41

Assuming that the investor is seeking a 6% return, here is the summary of the inputs necessary for the dividend growth model calculation:

D₁ = $2.41

g = 2.2%

k = 6.0%

With all necessary inputs in hand, we can now use the Dividend Growth Model formula to calculate the estimated fair value of the Verizon’s share price.

According to the dividend growth model the current fair value of Verizon’s stock is $63.42. The Verizon stock’s share price closed at the end of trading on December 21, 2018 at $54.92. Therefore, the dividend growth model indicates that Verizon’s stock is undervalued by 15.5%.

Before investors rush to their brokers and online trading accounts to submit buy orders for shares of Verizon’s stock, it is important to note that this analysis is just one piece of the overall stock analysis system. Furthermore, because of its simplicity, the dividend growth model calculation hinges on multiple assumptions.

Dividend Growth Model Assumptions

The dividend growth model assumes:

– Constant dividend growth rate.

– Constant dividend payout ratio.

– Zero debt in the company’s capital structure.

– Constant cost of capital, i.e. all investments have equal business risk.

– No external financing, the company finances all investment and expansion with its retained earnings.

– The constant internal rate of return is fixed and disregards an investment’s diminishing marginal efficiency.

– Perpetual earnings stream.

– No diminishing returns from corporate taxes.

In addition to the preceding assumptions, the model works only if the required rate of return (k) is higher than the dividend growth rate (g).

With these assumption in mind, let us evaluate a few alternative scenarios for Verizon’s stock.

Example 1b: Higher Requires Rate of Return

Let us evaluate a change in investor expectations. Going back to the actual figures in the first example, let us assume that a different investor is using the same model to analyze Verizon’s stock.

The first two inputs – the expected dividend over the next year and the dividend growth rate – will remain the same as they were in the previous example. However, let us assume that our second investor has been considering alternative investment opportunities that could potentially yield more than 6%. Therefore, this second investor requires 7% as the minimum rate of return. For this example, we have the following inputs:

D₁ = $2.41

g = 2.2%

k = 7.0%

Inserting those inputs into the dividend growth rate formula, we get:

With the revised rate of return figure, the dividend growth model indicates that the stock is overvalued by 9.4%.

These two examples are a good illustration of how different investors might look at the same equity and draw contrasting conclusions based on their personal preferences. Assuming that all other analytical indicators are favorable, the first investor should take a long position in Verizon’s stock. However, the second investor’s requirement for a higher rate of return makes Verizon’s stock currently appear overvalued. Therefore, the second investor should disregard Verizon’s stock and direct funds towards the alternative investments.

Example 2: Lower Dividend Growth Rate

Let us return to our first investor and the original evaluation. The initial evaluation indicated that the stock’s current share price is below the fair value estimated by the dividend growth model. However, before going ahead and taking a long position in the stock, the investor wants to consider an alternative scenario that affects one of the input variables. The investor wonders whether the stock would remain undervalued if Verizon reduced its dividend growth rate.

Let us assume a scenario where Verizon’s announced layoffs do not yield the desired cost savings and where Verizon fails to convert its 5G network technology first-mover advantage into increased market share and revenue growth. Under these circumstances, the company might decide to cut its dividend growth rate in half from 2.2% to 1.1%.

If the values of all other inputs remain the same, we get the following calculation:

The revised calculation indicates a current fair value of Verizon’s stock at $49.18 per share. This means that at the lower growth rate, the stock is overvalued by nearly 12%. Depending on whether the investor assigns a high degree of probability that this scenario will occur, the investor might reconsider the initial decision based on the first calculation and invest in alternative opportunities.

Summary

The dividend growth model’s simplicity is its greatest advantage and its greatest shortcoming simultaneously. Three simple input variables allow for quick and easy evaluation of estimated fair share-price value under multiple simple alternative scenarios. However, investors should conduct more than just a one-year dividend analysis to identify stocks with long-term growth prospects. While this model can be expanded to accommodate a multi-year analysis with variable growth rate, that process is a bit more complex and will be addressed at another occasion. Additionally, investors must evaluate the results of this model in conjunction with other financial metrics. Despite its shortcomings, the model’s formula still provides an easy method to determine whether an equity is undervalued or overvalued in the short term.

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