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Professor, what is a dividend growth model?
The dividend growth model is a valuation model. Using this model, the financial analysts and investors calculate the fair value of a stock and then decide if the stock is worth investing in or not.
An important point you should remember here is that this model operates on the assumption that the dividends grow annually. That can be either at a stable rate constant for a long time or different rate is broken into smaller time periods.
Professor, why do we call it a dividend growth model?
See, whenever the company is paying dividends to the shareholders, it is available on the stock market. You know that, right? So, when a potential investor is looking to invest in a stock, they evaluate their options. They check if the stock’s dividends will grow in the near future or not and will the investor get a return for their investment?
Do you understand this till here?
So, there are two terms that we use in a dividend growth rate model. The first one is undervalued. An undervalued stock means the present value of the stock is more than the market value of the stock.
The other one is overvalued. It means that the market values the stock for more than what it is worth. Or, the present value of the stock is less than the market value of the stock.
Professor, how do we know if the stock is undervalued or overvalued?
You do that by calculating the firm’s expected dividends and at what rate do they grow annually.
This is the formula to calculate the current stock price, where –
P = current stock price
D = value of the dividend of the next year
r = constant cost of equity capital for that company. In other words, the rate of return
g = constant growth rate in perpetuity expected for the dividends
Professor, can you please explain this with an example?
Of course, I can. You will understand everything quite clearly with an example.
Imagine a company called Corporation A declares that it provides an annual dividend of $3 per share for the year. I am a financial analyst and Mr X wants me to calculate the fair value of the company’s stock and tell if the investment is worthwhile or not.
I dig into the company’s records and see the past trends to see that the dividends for Corporation A grow at a constant rate of 6% in perpetuity. Also, the previous data reveals that the rate of return of the company is 13%.
Therefore, the price of the stock is
D = $3
r = 13%
g = 6%
P = $3/(13%-6%) = $3/7% = $42.86
This price, $42.86 is the present value of the stock as per the constant dividend growth rate model. If the stock market is selling the stocks of Corporation A for a price lower than $42.86, then the stock is undervalued and will be a good investment for Mr X.
If the market price of the stock is greater than $42.86, then the stock is overvalued and an unwise decision for Mr X.
Oh, we also call a constant dividend growth rate model as the Gordon Growth Model.
Professor, are there any basics of constant dividend growth rate model that we should be aware of?
There are a few assumptions that govern this model. They are –
- This model assumes that the company pays a constant growth dividend return to the shareholders.
- This model cannot work without dividends per share, growth rate and the rate of return.
- In this model, we assume that the company exists forever and that it pays dividends per share that grows at a constant rate.
- This formula gives us a fair value of the stock and does not consider marketing conditions. The only parameters this model is concerned with are dividend payout factors and market expected returns.
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