Understanding the Dividend Growth Model - SmartAsset

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:

The stock’s current price
The current annual dividend
The investor’s required rate of return
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.

Dividend Growth Model Limitations

The major weakness of the dividend growth model is that its accuracy is heavily dependent on correctly predicting dividend growth rates. Few companies consistently increase dividends at the same rate for long. Even those with many years of steady increases may encounter unexpected business challenges in the form of competitive, technological or regulatory changes, as well as overall economic conditions, that cause them to modify dividend growth rates that were followed in the past. Because of this, investors who use the dividend growth model need to monitor the stocks they are modeling and promptly update their models as new information becomes available.

Ultimately, dividend growth modeling is just one way to assess whether a security is trading at a fair price and is an attractive investment. To form an accurate and comprehensive picture, investors also need to consider company fundamentals, market conditions, economic trends and other factors.

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 on 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 financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
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