The official description of the Dividend Growth Model is; 'A stock valuation model that deals with dividends and their growth, discounted to today'.
This model assumes that the basis of the valuation of stock is:
- The Current Dividend
- Growth of the Dividend
- Required Rate of Return
It is best to describe this model by using an example. Assume that a stock is paying $2.00 per year in dividends, growing at 3.5% per year. The so-called variable item in this example is the investors required rate of return, which we will assume is 12.4%.
The formula for the Dividend Growth Model is:
Value = (Current Dividend * (1 + Dividend Growth)) / (Required Return - Dividend Growth)
Now, let's insert the assumptions for the example into this formula to see how it works:
Value = ($2 * (1 + .035)) / (.124 - .035)
Value = $23.26
Now, what does this mean? Basically this means that based on the current situation (the assumptions) this stock should yield a 12.4% average annual return at a price of $23.26. You might want to look at the required rate of return example for a discussion of that piece of this puzzle.