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Dividend Growth Model

Last week, I wrote about a stock picking strategy called the Dogs of the Dow [3]. 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 DividendInvestor.com [4]. 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.