The Common Stock of a company has the capacity for providing unexpected future cash flow inflows. Therefore, the stock’s valuation consists of two elements:
- The dividends that need to be paid each year.
- The prices investors expect to receive when the stock is sold off at a subsequent date.
Hence the sale price of the final saleable stock consists of two facets – Returns on Capital investments and the expected capital gains. The value of the stock is determined as follows:
Dt = Expected dividends at the end of the year
P0 = Actual market price of stocks
Pt = Expected price of the stock at the end of each year
g = Growth rate in the dividends over a period of time
The assumptions that the Dividend growth model infers is with regard to:
- The current dividend
- The expected growth of dividends
- The rate of return on the stocks
The example for Dividend growth model could be seen from the following example:
Company A has just paid a dividend of $1.15. Its stocks have a required rate of return Ks of 13.4%. The investor expects a dividend growth rate at the constant of 8% during future years.
Therefore, the expected dividends in Year 1 would be D1 = $1.15 (1.08) = $ 1.24.
In year 5, it would be:
$1.15 = (1.08)5 = $ 1.69.
It is seen in the above example that Dividend Growth Rate @ 8 % results in increasing rates of dividend in later years because the minimum rate of returns Ks is more than the growth rate g. Although the rate of dividend increases due to the impact of the present value of future earnings, the effective dividends would lower in later years. Growth in dividends normally arises on account of Earnings per Share (EPS).
There are a lot of factors that impact dividend growth like inflation, retained earnings, future outlook by the board of directors, etc. There are normally two types of companies- one that pays high rates of dividends and those that do not pay much in terms of dividends. Both these scenarios affect the market value of the stock. Increases in dividends temporarily increase stock values since investors prefer rising dividends.
However, when dividend payouts are high, there are may be lesser reserves to pay future dividends since a large portion of earnings is used towards dividend payments. Hence the management needs to provide for future dividends. In the second scenario, since dividends are low, there would be ample reserves that need to be invested. The Board of Directors would need to find profitable avenues for investments in consonance with the company’s policies and practices.