Dividend growth modeling helps investors determine a fair price for a company’s shares, using the stock’s current dividend, the expected future growth rate of the dividend and the required rate of return for the individual’s portfolio and financial goals. The dividend growth model is relatively easy to perform and can provide a helpful way to decide whether or not to invest in a particular security. Just keep in mind that the assumptions used may not turn out to be accurate.

A financial advisor can help you as you develop your dividend investing strategy and tactics.

Dividend growth modeling may be best applied to companies known as Dividend Aristocrats. These are companies that have increased their dividends annually for at last 25 years. There are approximately 60 members of the Dividend Aristocrats group. Their reliable dividend increases make it easier to forecast their future dividend growth, which can boost the accuracy of dividend growth models.

The Dividend Growth Formula

The formula for the dividend growth model, which is one approach to dividend investing, requires knowing or estimating four figures:

1. The stock’s current price
2. The current annual dividend
3. The investor’s required rate of return
4. The expected rate at which dividends will increase

The current stock price and current annual dividend are can be gotten from online market listings or from company reports. These are the only two figures in the formula that don’t require making any assumptions.

The required rate of return represents the smallest return on an investment that an investor will consider. This can be a more or less arbitrary figure, depending on the investor’s individual financial goals. The historical average rate of return on equity investments is approximately 10%. Often an investor’s required rate of return will be within a few percentage points of this figure, such as from 7% on the conservative side to 12% for more aggressive investors. Of course, there is no guarantee an investor will achieve this rate of return.

The expected dividend growth requires another significant assumption. Generally, this is arrived at by looking at the historical trend of a company’s dividend growth. For example, if it has been increasing its dividend by 3% annually for many years then 3% is likely to be used as the expected future dividend growth rate. Again, there is no guarantee that the future will look just like the past.

Once these figures are determined, the fair price can be determined by subtracting the expected rate of dividend growth from the required rate of return and dividing that into the current annual dividend. The formula looks like this:

Fair price = current annual dividend divided by (desired rate of return – expected rate of dividend growth)

For example, consider a stock with a $5 annual dividend and an expected dividend growth rate of 4%. The investor’s required rate of return is 10%.

Fair price = $5 divided by (10% minus 4%)

This becomes:

Fair price =  $5 divided by 6%

Which becomes:

Fair price = $83.33

If the stock is trading at, say, $90, the dividend growth model suggests it is overvalued compared to its fair price and may not be a good investment. If it is trading at less than the fair price of $83.33, it may be undervalued and deserve a second look.

A more advanced formula can be used when the future growth rate of dividends is not expected to be stable.

Can You Use Dividend Growth Modeling for Retirement Planning?

You can use dividend growth modeling to plan for a steady income during retirement. This approach helps you calculate a stock’s fair price and assess its potential for dividend growth.

You can do this by focusing on companies with a history of consistently increasing dividends, which could help protect your purchasing power as a retiree. These stocks provide growing income over time, reducing the need to sell assets to cover daily expenses and helping you maintain financial security.

As an example, let’s say you need $30,000 annually in retirement income. You could use dividend growth modeling to identify stocks with an average dividend yield of 3%. This means you’d need to invest $1 million in these stocks to generate your desired income ($30,000 is 3% of $1 million). So, if you can select companies with a history of increasing dividends by 3% annually, your income could grow over time to keep up with inflation.

Additionally, you should look into diversifying your portfolio with dividend-paying stocks from various industries to add stability to your income. Spreading investments across sectors minimizes the impact of market changes in any one area, ensuring a more reliable and balanced income stream.

Keep in mind, though, that dividend growth modeling has limitations. It relies on predictions about future dividend growth rates, which may not align with actual outcomes.

Dividend Growth Model Limitations

Few companies can maintain consistent dividend increases indefinitely. Market conditions, competition, regulatory changes, or economic downturns can force even well-established companies to adjust their dividend policies unexpectedly.

Because of this, you need to actively monitor the stocks you’re modeling. Regularly updating your assumptions and calculations based on new information is essential to maintaining a realistic view of a stock’s value. Neglecting this step could lead to inaccurate evaluations and poor investment decisions.

While helpful, the dividend growth model should not be your only tool for assessing an investment. You should also analyze company fundamentals, market trends and broader economic factors. Combining this model with other methods will give you a more complete and accurate understanding of whether a stock is a good fit for your portfolio.

Bottom Line

Dividend growth modeling uses a mathematical formula to assess the fair value of a security. It uses figures for current trading price, current annual dividend, expected future dividend growth rate and required rate of return. By plugging these figures into the formula an investor can estimate how far a security is from its fair value. Just remember: this model is just one of several ways to evaluate a stock’s price, and the model calls for making a number of assumptions that may not match what eventually happens.

Tips for Investing

• Using dividend growth modeling is just one way to evaluate whether a security would be an attractive addition to a portfolio. A financial advisor can help an investor apply other useful tools to help guide investment decisions. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• If your investments pay off, you may owe the capital gains tax. Figure out how much you’ll pay when you sell your stocks with our capital gains tax calculator.

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