The dividend growth model is a method of estimating a company’s cost of capital.
The dividend growth model is a method of estimating a company’s cost of capital. The cost of capital is closely related to the company’s required rate of return, which is the percentage of return a company must earn on business opportunities. Companies use this model to perform a stock valuation related to the dividends and growth of their stock, which is discounted to the current dollar value. This allows business owners and managers to use some basic assumptions to estimate at what stock price a company will earn its required rate of return.
The basic assumptions in the dividend growth model assume that the value of a stock is derived from the company’s current dividend, the historical percentage of dividend growth, and the required rate of return for business investments. Business owners and managers can determine their own rate of return or use a standard rate from the business environment. Standard rates of return can be the historical percentage return on a national stock market or the rate of return a company can earn by investing in other business opportunities.
The dividend growth model is often calculated using the following formula: value equals [dividendo atual vezes (um mais a porcentagem de crescimento do dividendo)] divided by the required rate of return minus the dividend growth rate percentage. For example, suppose a company pays a dividend of $1.50 United States Dollars (USD), has a historical growth rate of 2 percent per year, and a company requires a rate of return of 12 percent. Using this formula, the stock value to earn a required rate of return is $15.30 USD: (1.50 x (1 + 0.02)) / (0.12 + 0.02). If a company wants to earn its 12% rate of return under these conditions, it must buy shares when they hit $15.30 on the open market.
Private companies or private companies that do not issue stock or pay dividends can use the dividend growth model to estimate the amount at which they will earn their rate of return. Instead of using information related to dividends, companies can supplement information related to their net income. Companies can use their current net income for a recent accounting period and their earnings growth rate percentage in the dividend growth model. Although this results in a different value, it is still a useful number.
A big drawback to this calculation is the fact that it uses assumptions to calculate the value of a stock. These assumptions may not accurately reflect current market conditions or may change rapidly depending on a country’s monetary or fiscal policy that changes the way companies issue shares or pay dividends. Business owners and managers need to take these changes into account, and not create hard and fast business policies based on the dividend growth model.