Dividend Growth Model: Concept & Uses

The Dividend Growth Model is one of the most reliable methods for valuing mature, dividend-paying firms. It assumes that dividends will grow at a steady rate and that this growth can continue indefinitely.

Key Reasons to Use DGM:

• To estimate shareholder value using future dividend expectations.
  

• To calculate the cost of equity (required rate of return for shareholders).
  

• To compare stock valuations across companies or industries.
  

• To support investment decisions based on dividend growth assumptions and payout consistency.

This model is particularly applied to income-focused valuation studies.

The DGM’s fundamental formula determines the current stock price as the present value of future dividends expected to grow at a constant rate.

Formula:

• P₀ = D₁ ÷ (r – g)

Where:

• P₀ = Current stock price
  

• D₁ = Expected dividend next year
  

• r = Required rate of return (cost of equity)
  

• g = Dividend growth rate

Condition:

This model works only if r > g, ensuring the denominator remains positive.

The Gordon Growth Model (GGM) is the most common form of DGM, assuming that dividends grow at a constant rate indefinitely.

Example:

If a company’s expected dividend next year (D₁) is ₹10, required return (r) is 12%, and growth rate (g) is 4%:

P₀ = 10 ÷ (0.12 – 0.04) = ₹125

This calculation values the stock at ₹125 based on expected dividend payments.

Use Case:
Applicable to mature firms with stable dividend policies (e.g., utilities, FMCG companies).

Some companies experience fluctuating dividend growth before stabilising. The multi-stage version extends DGM to account for varying growth rates across periods.

Steps:

1. Estimate dividends during the high-growth phase.
   

2. Discount them back to the present.
   

3. Calculate the terminal value using the Gordon formula (constant growth phase).
   

4. Add both components to derive the intrinsic value.

This approach may be applicable to companies transitioning from rapid expansion to stable maturity.

The Dividend Growth Model can also be rearranged to estimate a firm’s cost of equity (r) — the return expected by investors.

Formula:

• r = (D₁ ÷ P₀) + g

Example:

If a company pays a ₹5 dividend, its market price is ₹100, and the growth rate is 6%:

r = (5 ÷ 100) + 0.06 = 11%

This indicates that investors would expect an 11% return given its dividend profile.

The Dividend Growth Model operates under certain key assumptions:

• The firm pays regular and growing dividends.
  

• The growth rate (g) remains constant indefinitely.
  

• The required rate of return (r) exceeds the growth rate.
  

• The company’s business and earnings remain stable over time.
  

• Dividends accurately reflect profitability and cash flow trends.

If these assumptions don’t hold (e.g., irregular payouts or volatile earnings), other valuation methods may be more appropriate.

The following examples illustrate how the Dividend Growth Model may be applied:

Example 1 — Stock Valuation

A firm’s current dividend = ₹8; growth = 5%; required return = 10%.

P₀ = 8 × (1 + 0.05) ÷ (0.10 – 0.05) = ₹168

Example 2 — Cost of Equity Estimation

Given market price ₹120, next-year dividend ₹7.20, and growth 4%:

r = (7.20 ÷ 120) + 0.04 = 10%

These computations highlight how DGM supports both valuation and cost-of-equity analysis.

Here are the main benefits and constraints of using the Dividend Growth Model:

Advantages:

• Simple and mathematically intuitive.
  

• Focuses on long-term cash returns (dividends).
  

• Suitable for stable, dividend-paying companies.
  

• Helps estimate both value and cost of equity consistently.

Limitations:

• Ineffective for firms not paying dividends.
  

• Assumes constant growth, which may not be realistic.
  

• Sensitive to small changes in r and g values.
  

• Not suitable for high-growth or volatile sectors.

The model is most useful when:

• The company has a consistent dividend history.
  

• Dividends represent a meaningful portion of total shareholder return.
  

• The business operates in a low-volatility industry.
  

• Long-term growth and payout ratios are predictable.

Examples:

• Banks, insurance firms, consumer goods companies, and utilities.

The Dividend Growth Model provides a logical, income-based method to value dividend-paying stocks and calculate cost of equity.

Key Takeaways:

• Formula: P₀ = D₁ ÷ (r – g)
  

• Most effective when dividends and growth remain stable.
  

• Useful for valuation, yield analysis, and equity cost estimation.
  

• Typically not suitable for high-growth or non-dividend-paying firms.
  

• A foundational concept in equity valuation for dividend-paying firms.

This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.