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:

  1. The current dividend payout
  2. The growth rate of the dividend
  3. 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 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.

{ 19 comments, please add your thoughts now! }

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19 Responses to “Dividend Growth Model”

  1. Jessica says:

    I thought Chase bought WaMu?

    • jim says:

      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

      • Eric N. says:

        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… 😕

        • jim says:

          There’s been so much consolidation that I got confused. 🙂

          • Eric N. says:

            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! 😀

    • antonio says:

      i need to get the dividend yield of bny mellon bank for a class for year 2008 and 20009

  2. Frugal Dad says:

    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.

  3. Kevin says:

    It appears you meant to say $0.32 a quarter and $1.28 a year.

  4. M says:

    In your example is the dividend “$0.32 a year” or $0.32 a quarter?

  5. jim says:

    You guys are right, good catch, thanks!

  6. Rob says:

    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.

  7. 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.

  8. Manshu says:

    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.

  9. thomas says:

    Isn’t this one of the items discussed in the book “#1 rule” or something like that?

  10. 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

  11. Anonymous says:

    thanks this has really helped me to understand

  12. Nice article, thank you for posting. Big fan of dividend investing. I agree with Dividend Growth Investor’s comments. The more I think about, I am not sure if this formula helps to determine if the stock in undervalued (relative to it’s dividend payment) or not.

    If you use your example and solve for Rate of Return (using $14.28 for a value), then the Rate of Return is approx. 22% (if I did not mess up the math).

    Do you have a source for this equation? Would be curious to read more about it.

  13. I believe you have the wrong end of the stick. The formula you gave is correct as is the maths; however, you appear to have missed the point of the Gordon growth model.

    The point of the model is that should you wish a return of 20% then the MAXIMUM you should pay for the share would be $18.38. If you were to pay more than $18.38 then the return would be less than 20%.

    Share prices usually reflect the value of this model, the fact that the share was at a far lower rate does not mean it would not return 20% (however, the market is showing that it is unlikely to; hence the lower price). That is to say that if the return was anticipated to be 20% then the value of the share would be VERY close to $18.38

    Transposing the formula and using the share value should give you an indication as to it’s expected returns.

  14. Hi Jim,

    I agree that the EPS is one of the most important factors; however, one has to consider the broader picture especially profits. Companies exist to increase shareholders wealth, to this end dividend growth is not always a good investment medium.

    Dividends are a share of the profits, and a useful return for revenue investors; however they do come at a cost. The company has to decide whether paying a dividend would be beneficial to the investor. Payout too much and then their cost of capital may increase which would reduce next years profits. Reduced dividends can actually be a better investment, as although the dividend reduces the share price increases. As most will notice companies that do give dividends have a rapid drop in share prices once they are announced. This is due to Cum Div (ie the shares sold have a dividend value) and Ex Div (where the share value drops as the dividends are paid to the owner of the shares at that time; regardless of whether they sell the share before the dividends are paid – usually a 6 week period)

    Shares are about risk and return, the higher the risk of a company making a profit, the higher one would expect the returns. Knowing the type of business you are investing in, its expected profit and how its rivals are doing is a far better way of investing.

    Each industry will have leaders, working out who they are against their rivals will give a better return than going by historical data: Which basically only tells you they did, not what they will do.

    EPS is a ratio, and like all ratios it is dependent upon a nominator and denominator it is therefore important to look at which one has changed.

    in the case of EPS the ratio is

    profit for the year/number of Ordinary shares.

    this means that if the company has issued a lot of new ordinary shares (to raise capital to expand/take advantage in Debt reduction due to lower rates etc) then the EPS will drop.

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