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Dividend Growth Model - How to Value Common Stock with a Constant Dividend and "No Growth" How do we value common stocks for which we know the future prices 2 to more years or periods down the line? For instance, we may be able to estimate what a stock will be worth 2 years from now, and this does not fit our current formula where P1 equals the price of the stock in one year or period. Here’s how to solve this problem. A common stock in a company with a constant dividend is much like a share of preferred stock because the dividend payout does not change. Financial managers also know that the rate of growth on a fixed-rate preferred stock is zero, and thus is constant through time. For a zero growth rate on common stock, thus D1 will be:

 D1 = D2 = D3 = D = Constant

This implies that the dividend payout in Year 2 will be the same as the dividend payout in Year 1, and likewise the dividend payout in Year 3 will be the same as in Year 4, thus D remains constant. Therefore, we can tweak this formula to come up with a new common stock valuation formula:

 P0 = [D / (1 + r)1] + [D / (1 + r)2] + [D / (1 + r)3] + [D / (1 + r)4] + [D / (1 + r)5]

Since the dividend is always the same, the stock can be viewed as an ordinary perpetuity with a cash flow equal to D every period, thus the per-share valuation of the common stock is given by this formula:

 P0 = D / r

Where:

 P0 = Current price of the stock D = Dividend payout at the end of this period r = required rate of return

As an example, consider Cofta Corp. has a policy of paying \$20 per share dividend every year, and the company expects to continue paying out this dividend indefinitely. What will be the value of a common share of stock if the required rate of return is 15%?

 P0 = D / r P0 = \$20 / 0.15 P0 = \$133.33 / share

What if we knew the dividend for this company always grows at a steady rate every year. We will call this growth rate g. If we let D0 be the dividend just paid, then the next dividend D1 will be:

 D1 = D0 x (1 + g)

Where:

 D1 = Value of dividend to be paid next year D0 = Value of dividend paid this year g = Growth rate of dividend

Having said this, what is the formula for dividend payout in 2 periods?

 D2 = D1 x (1 + g)D2 = [D0 x (1 + g) x (1 + g) D2 = D0 x (1 + g)2

We can repeat this process to come up with the dividend at any point in the future. Thus, the dividend Dt in t periods in the future is given by:

 Dt = D0 x (1 + g)t

Example of Dividend Growth

TD Dominion bank has just paid a dividend of \$5 per share and the dividend grows at a steady rate of 6% per year. Based on this information, what will the dividend be in 5 years?

 Dt = D0 x (1 + g)t Dt = \$5 x (1 + 0.06)5 Dt = \$5 x (1 .06)5 Dt = \$5 x 1.3382 Dt = \$6.691

Thus in 5 years, the dividend will grow from \$5 per share to \$6.691 thus growing a total of (\$6.691 - \$5) = \$1.691 