How to Calculate Share Price Using Dividend Growth Model
The dividend growth model is a popular method used by investors to estimate the intrinsic value of a stock. It is based on the assumption that the value of a stock is equal to the present value of its future dividends. This model is particularly useful for companies that have a consistent history of paying dividends and are expected to continue doing so in the future. In this article, we will discuss how to calculate share price using the dividend growth model.
Understanding the Dividend Growth Model
The dividend growth model is also known as the Gordon Growth Model, named after Myron J. Gordon, who developed it in the 1960s. The formula for calculating the intrinsic value of a stock using the dividend growth model is:
Intrinsic Value = D1 / (r – g)
Where:
– D1 is the expected dividend per share in the next period.
– r is the required rate of return, or the discount rate.
– g is the growth rate of dividends.
The expected dividend per share in the next period (D1) can be estimated by multiplying the current dividend per share by the expected growth rate of dividends. The required rate of return (r) is the rate of return that investors demand for holding the stock, and the growth rate of dividends (g) is the rate at which the company is expected to increase its dividends in the future.
Calculating the Intrinsic Value of a Stock
To calculate the intrinsic value of a stock using the dividend growth model, follow these steps:
1. Find the current dividend per share (D0) and the expected growth rate of dividends (g). This information can be found in the company’s financial statements or from financial websites.
2. Estimate the expected dividend per share in the next period (D1) by multiplying the current dividend per share (D0) by the expected growth rate (g).
3. Determine the required rate of return (r) based on the risk of the stock. This can be estimated by looking at the company’s beta, which measures its volatility compared to the market. You can also use the capital asset pricing model (CAPM) to calculate the required rate of return.
4. Calculate the intrinsic value of the stock by dividing the expected dividend per share in the next period (D1) by the difference between the required rate of return (r) and the growth rate of dividends (g).
Example
Let’s say a company has a current dividend per share (D0) of $2.00 and an expected growth rate of dividends (g) of 5%. If the required rate of return (r) is 10%, the intrinsic value of the stock can be calculated as follows:
D1 = D0 (1 + g) = $2.00 (1 + 0.05) = $2.10
Intrinsic Value = D1 / (r – g) = $2.10 / (0.10 – 0.05) = $42.00
According to the dividend growth model, the intrinsic value of the stock is $42.00. If the current market price of the stock is below $42.00, it may be considered undervalued, and vice versa.
Conclusion
The dividend growth model is a valuable tool for investors to estimate the intrinsic value of a stock. By understanding the assumptions and calculations involved, investors can make more informed decisions about their investments. However, it is important to note that the dividend growth model has limitations, such as its reliance on assumptions about future dividends and growth rates. As with any investment model, it is crucial to conduct thorough research and consider other factors before making investment decisions.
