Dividend Growth Model

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.



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