Dividend Growth Model - How to Value Common Stock with a Constant Dividend and Steady Growth

• Part 10.1 - How to Value Common Stock given Required ROI (Return on Investment) and Dividends
• Part 10.2 - Dividend Growth Model - How to Value Common Stock with a Constant Dividend and Steady Growth
• Part 10.3 - Dividend Growth Model - How to Value Common Stock with a Constant Dividend and "No Growth"

If the dividend grows at a steady rate, we do not need to forecast an infinite number of future dividends; however we just need to come up with a single growth rate which is a lot simpler. Taking D0 to be the dividend just paid and g to be the constant growth rate, the value of one share of stock can be simply written as:

This can be cut down to the following:

We have therefore just derived the dividend growth model which is a model that determines the current price or value of a share of stock as its dividend next period divided by the discount rate minus the dividend growth rate.

Example

Consider a case where the current dividend payout is $1.80 and the rate of return required is 15% while the constant growth rate is 5%. What will the current price of the stock be?

Bank of America Dividend Growth Model Application - Example

Bank of America announces its next dividend will be $2 a share and from research we know that investors typically require a 14% annual rate of return from American banks, thus this will be the required rate of return. The bank increases its dividend at a steady rate of 8% a year. Based on the dividend growth model, what is the value of the Bank of America stock today? What is the value in 4 years?

a) Since we are already given the next dividend as $2 per share, we will not multiply D1 with (1 + g) as it is given as $2. Having said this, the dividend growth formula we will use is:

b) Since we already know the dividend in one year, the dividend in four years is equal to:

Therefore, the price of the stock in four years will be:

Dividend Growth Sample Problems – Example 1

ABC Company has just paid a $1.5 dividend and dividends are expected to grow at 5% per year. Return on shareholder’s equity is 12%. What is the stock price?

Dividend Growth Sample Problems – Example 2

ABC Company is a declining company and dividends are expected to decrease by 4% a year. Next year’s dividends are expected to come in at $2 per share and the required shareholder return is 8%.

a) What is the current price of the stock?