The dividend growth model is a method to estimate a company’s cost of equity. The cost of equity is closely related to the company's required rate of return, which is the return percentage a company must make on business opportunities. Companies use this model to conduct a stock valuation relating to their stocks' dividends and growth, which is discounted back to today’s dollar value. This allows business owners and managers to use a few basic assumptions to estimate at what share price a company will earn its required rate of return.
Basic assumptions in the dividend growth model assume a stock’s value is derived from a company’s current dividend, historical dividend growth percentage, 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 return rates can be the historical return percentage from a national stock exchange or the return rate a company can earn from investing in other business opportunities.
The dividend growth model is often calculated using the following formula: value equals [current dividend times (one plus the dividend growth percentage)] divided by the required rate of return less the dividend growth rate percentage. For example, assume a company pays a dividend of $1.50 US Dollars (USD), has a historical growth rate of 2 percent per year, and a company requires a 12 percent rate of return. Using this formula, the stock value to earn a required rate of return is $15.30 USD: (1.50 x (1 + .02)) / (.12 + .02). If a company desires to make its 12 percent rate of return under these conditions, the company should purchase stock when it reaches $15.30 in the open market.
Private companies or closely held businesses who do not issue stock or pay dividends can use the dividend growth model to estimate the value at which they will earn their rate of return. Rather than using information relating to dividends, companies can supplement information relating to their net income. Companies can use their current net income for a recent accounting period and their income growth rate percentage in the dividend growth model. Although this will result in a different value, it is still a useful figure.
A major drawback to this calculation is the fact that it uses assumptions to calculate a stock’s value. These assumptions may not accurately reflect current market conditions or quickly change based on a nation’s monetary or fiscal policy that changes how businesses issue stock or pay dividends. Business owners and managers must account for these changes by not creating hard-and-fast business policies based on the dividend growth model.