The Dividend Growth Model: Definition and Formula

The dividend growth model is just one of many analytic strategies devised by financial experts and investors to navigate thousands of available investment options and select the individual equities that are the best fit for their specific portfolio strategy.

The specific purpose of the dividend growth model valuation is to estimate the fair value of an equity. Once this fair value is calculated, investors can compare the fair value with the current share or unit price to determine whether a particular equity is overvalued or undervalued. Based on this comparison, investors can decide which equities to buy and sell to optimize their portfolio’s total returns.

For the purpose of dividend growth model calculation, we make assumption on the rate of future growth of dividend distributions. These dividend distributions can rise at  constant growth rates in perpetuity or at variable rates for any given period under consideration.

The specific formula for the dividend growth model calculates the fair value price of an equity’s share or unit in relation to the current dividend distribution amount per share, as well as projected dividend growth rate and the required rate of return. While the required rate of return (RRR) has different interpretation for different uses, in this case, the minimum rate of return denotes the least amount of return on investment that an investor would accept for taking a position in a particular equity.

Generally, the required rate of return measures the minimum return that investors desire for the level of risk associated with a particular investment. Corporate finance uses the required rate of return measure to identify profitable projects and corporate investments. Additionally, for equity valuation, the required rate of return is equivalent to the weighted average of cost of capital.

For determining equity valuation under the dividend growth model, the formula is as follows:

Where:

P = fair value price per share of the equity

D = expected dividend per share one year from the present time

g = expected dividend growth rate

k = required rate of return

The assumption in the formula above is that g is constant, i.e. that the dividend distributions grow at a constant rate, which is one of the formula’s shortcomings. However, the formula still provides an easy method to determine whether an equity is undervalued or overvalued in the short term.

Nevertheless, the formula can easily be adapted and used in more complex models that allow for multi-year analysis with variable dividend distribution growth rates for each year. To better illustrate the formula and its application, here is an example.

Steady growth rate example

Let us assume that ABC Corporation’s stock currently trades at $10 per share. The company’s current quarterly dividend distribution is $0.25, which corresponds to an expected total annual dividend payout of $1.00 for the upcoming 12-month period. Furthermore, the ABC Corporation has been increasing its total annual dividend payout amount by an average of 4% per year over the past decades. Therefore, for the purpose of this calculation, it is relatively safe to assume that the company might continue this growth rate in the upcoming year. Based on opportunity cost of investing in alternative investment types, let us assume that to allocate our funds into the shares of ABC Corporation we expect a return of no less than 12%.

Plugging the information above into the dividend growth model formula,

we get:

Based on the assumptions listed above, ABC Corporation’s current share price is undervalued and has 25% room on the upside before it reaches its current fair value. Therefore, the dividend growth model suggests that taking a long position in the ABC Corporation’s stock might be a good investment idea. The key word is “might”, because this calculation only provides a single data point in the overall equity evaluation and requires additional analysis.

In a different scenario, let us assume that the growth rate and the required rate of return remain the same at 4% and 12%, respectively. However, the quarterly dividend distribution for the next year is now $0.18, which converts to a $0.72 expected cumulative dividend payout for the upcoming year.

In this case the dividend growth model calculation yields a different result,

The $9 calculated fair value of the ABC Corporation’s share price is 10% lower than its current $10 trading price. Therefore, under these conditions, the share is overvalued, and investors should consider looking elsewhere for their minimum required returns.

Variable growth rate example

To expand the model beyond the one-year time horizon, investors can use a multi-year approach. Let us assume that, based on historical information, we estimate that the total annual dividend should grow at 5% in the second year, 6% in the third year, 7% in the fourth year and then continue to grow at 5% per year permanently. Furthermore, we assume the $1.00 annual dividend payout for the first year and a 12% required rate of return.

First, we calculate the expected annual dividend payouts for the first four years with variable dividend growth rates.

Year 1: $1.00

Year 2: $1.00 + 5% = $1.05

Year 3: $1.05 + 6% = $1.11

Year 4: $1.11 + 7% = $1.19

Perpetuity: $1.19 + 5% = $1.25

Next step is to calculate the present value (PV) of the expected future dividend payments using the formula:

Where,

n = year number

k = required rate of return

Therefore, we have,

PV Year 1: $0.89

PV Year 2: $0.84

PV Year 3: $0.79

PV Year 4: $0.76

The fair value of the dividends for Perpetuity is calculated using the dividend PV for year 4 in the standard dividend growth formula.

Therefore,

$0.76 / (12% – 5%) = $17.86

From the above value, we calculate the present value of the expected dividends over the next four years as:

$17.86 / (1.12)⁵ = $10.13.

Finally, we can calculate the fair value of the stock as:

Dividend PV Year n

or,

$0.89 + $0.84 + $0.79 + $0.74 + $10.13 = $13.41

Since the current fair value of $13.41 is above the current $10 trading price, the stock is undervalued.

This entire multi-year calculation can be represented in the table below.

Practical application

Investors must conduct more than just a one-year dividend analysis to identify dividend-paying equities with potential multi-year returns. While the dividend growth model is a simple and fast way to get general indications about projected value of equity share prices, the model also has a few shortcomings.

Dividends very rarely increase at a constant rate for extended periods. Additionally, forecasting accurate growth rates few years in the future can be difficult to accomplish. Therefore, the dividend growth model results change constantly, and the calculations must be repeated as well.

Despite its shortcomings, the dividend growth model does offer a good starting point for equity selection analysis. However, investors must evaluate additional measures in conjunction with the dividend growth model to generate a more extensive set of data for evaluating potential investments.

In addition to dividend growth data, sales growth, profit margin trends, earnings per share (EPS) increases, as well as dividend payout ratio changes are indicators that investors must consider before making a final investment selection. Furthermore, investors must continuously evaluate potential investments through the dividend growth model to compensate for changing input values and personal requirements.

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