The Dividend Growth Model

One of the ways that you can screen for a good dividend stock pick is to make use of the dividend growth model. You can calculate what the value of the stock should be, based on its dividend, to provide you with the return that you need to make it worth the purchase.

Calculating Stock Valuation Based on Dividend Growth

This stock valuation model takes a look at divided growth and uses it to help you decide whether or not the investment is a good buy. The formula use is based on three factors:

1. Current dividend (per-share – full year dividend pay out)
2. Growth of the dividend (per year – the five year dividend growth can give you a good idea)
3. Required rate of return: What you “need” the investment to return in order for you to think it worth it to purchase the stock.

Once you know that information, you can plug it into the following formula:

(current dividend x (1 + dividend growth)) / (required return – dividend growth)

Dividend Stocks Online has handy lists that show you current dividend yield, and other information about yield growth. So, for our example, we’ll use Verizon (VZ). According to The Motley Fool, VZ is on track for a full year pay out of $1.95 per share. DSO puts the five-year annual dividend growth at 3.51%. Now, let’s say that I would need 10% for a required rate of return. As of Friday, May 27, 2011, VZ has closed at $36.67.

It’s time to plug in some numbers, and hope that I can still do junior high school math with a calculator:

1. Current dividend = 1.95
2. Growth of dividend = 0.0351
3. Required rate of return = 0.1

(1.95 + (1 + 0.0351))/(0.1 – 0.0351) = 1.9851/0.0649 = $30.59

Basically, this model means that this stock should be at $30.59 in order for me to get a 10% annual return, based on its dividend growth.  It is also worth noting that this model could also be interpreted as an indication that VZ is currently overvalued, since it seems to indicate that VZ has a price higher than its valuation.

Problems with the Dividend Growth Model

There are weaknesses in almost any model, and this one is no different. Dividends do not always remain the same; they can be cut. Dividend growth is not going to remain constant, and this model assumes constant growth in perpetuity. In addition to looking at the dividend growth model of stock valuation, consider a few other factors when making a decision:

• History of regularly dividend increases (dividend aristocrats are those that have raised dividends every year for 25 years)
• Business model of the company
• A dividend adequately covered by earnings

There is no way to completely predict what any investment will do. However, you can do a little research, and choose stocks that show good promise going forward.