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Dividend Growth Model
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Last week, I wrote about a stock picking strategy called the Dogs of the Dow. The gist of the strategy is that you take the highest dividend yielding stocks in the Dow Jones Industrial Average and make equal investments into each. The strategy hinges entirely on the use of the dividend as a way of valuing a company. I personally don’t subscribe to the strategy but I do believe dividend investing is a very important concept, especially since dividends are taxed at a lower rate!
In keeping with that thinking, I’ve been making some small investments into companies that have decent dividend yields because I think the stock market took a dump on both the good companies and the riff raff. In my research about dividends in general, I stumbled onto what’s known as the dividend growth model, which is a way of valuing a stock based on its dividend. Like the other million ways you can evaluate the value of a stock, it’s by no means predictive but can help you make investment decisions.
Dividend Growth Model
To calculate the value of a stock based on the dividend using the dividend growth model, you’ll need three pieces of information:
- The current dividend payout
- The growth rate of the dividend
- Your required rate of return
You can look up the current dividend payout and the growth rate of the dividend online. The “required rate of return” is something you decide and the impact it has will be explained momentarily. The equation for calculating the value based on those three values is:
| Value = | (Current Dividend * (1 + Dividend Growth)) (Required Return – Dividend Growth) |
One thing to keep in mind, your required return has to exceed the growth rate of the dividend otherwise the equation falls apart.
So, let’s look at an example: Bank of America, the biggest Dog of the Dow, and proud new owner of Merrill Lynch and Countrywide. On January 6th, when I wrote this article, Bank of America closed at $14.28 a share with a dividend yield of 8.96% ($0.32 a quarter, $1.28). Bank of America also had a five year dividend growth rate of 12.17% according to DividendInvestor.com. Armed with that information, and the assumption that my required rate of return is 20%, we can calculate:
Value = (Cur. Div. * (1 + Div. Growth)) / (Req. Return – Div. Growth)
Value = ($1.28 * (1 + 0.1217)) / (0.20 – 0.1217)
Value = ($1.28 * (1.1217)) / (0.0783)
Value = $18.38
Based on the dividend growth rate of 12.17%, the model says that BAC should be worth $18.34, a premium over its current share price.
This model is a little tricky because it makes a huge assumption, that you assume dividends grow at a constant rate forever (in perpetuity), which may or may not be the case. It’s not as crazy an assumption as some other models but you should be aware of it. There are also the typical risks associated with investing based on dividends, since they can change at any time. However, it serves as a good data point during your analysis.
{ 15 comments, please add your thoughts now! }
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I thought Chase bought WaMu?
I get them confused myself all the time but it was JP Morgan:
JPMorgan Chase to Buy Washington Mutual
In a deal brokered by the federal government, JPMorgan Chase will pay $1.9 billion for deposits and branches. WaMu depositors will be protected
Wait, it might be just me but do you mean in your post that Bank of America bought WaMu? That’s how I read it hence the confusion…
There’s been so much consolidation that I got confused.
haha I don’t blame you. It’s mind boggling to keep up.
P.S. I seriously love this new threaded feature. It makes it organize and (dare I say) more fun to comment!
The dividend growth model is an interesting valuation tool. I personally like the idea of investing in stocks for passive dividend growth, and the formula you’ve presented would be yet another way to screen potential buys.
It appears you meant to say $0.32 a quarter and $1.28 a year.
In your example is the dividend “$0.32 a year” or $0.32 a quarter?
You guys are right, good catch, thanks!
BAC is sitting at $10.65 per share right now.. far below the $14.28 of just a few days ago. I’m going to have trouble *not* buying some more of this stock if it stays at its current level…. Under 11 bucks a share is almost ridiculous for this stock.
No doubt it makes your formula look even more impressive
$10.65 cost vs $18.38 estimated value.
I bought BAC in 2007 because of its dividend yield. I sold it in 2008 when it cut its dividend. BAC will probably cut it more this year. I think it’s a terrible investment right now, even as a dividend play. I believe the BAC CEO will be canned shortly. Also, the Dogs of the Dow model failed miserably last year because too many of the dogs were in financials. Finally, look for Obama and crew to increase the tax rate on dividends, at least for people who can actually afford to buy stocks. It’s a scary time to be a dividend investor.
Dividend investment is good if you are going to invest in cash rich companies. Companies that are able to generate cash quarter after quarter, year after year are a good bet.
So it is a good idea to look at the Cash Flow Statement of the company when using this formula.
Isn’t this one of the items discussed in the book “#1 rule” or something like that?
Good formula. It is risky though because a stock like Bank of America is going to have to cut or eliminate its dividend. I think that you have to take expected earnings growth into account and then compare it to the historical payout rate.
Jim,
As a dividend growth investor myself I do not rely on models that assume a constant growth in dividends. Instead dividend investors should look for:
-Adequate stock valuation
-Sound business model ( beware of cyclical stocks)
-Long history of dividend growth ( 10 or more yrs, preferably 25)
-Decent initial yield to compensate even if dividend growth slows down
- make sure the dividend is adequately covered by earnings
- make sure the company has a solid history of EPS growth