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