The dividend valuation model is a mathematical formula which uses a company’s potential value to determine share price via the dividend. It is a common tool of stockbrokers who are trying to predict the future value of a stock. This method considers all available information about the stock in order to get as close as possible to a true future value and is often accurate enough to be a useful decision making tool. It is one of the types of dividend discount models and is also know as Gordon model.
Dividend valuation models are only effective for companies that distribute dividends. When using the dividend valuation model, it is assumed that dividends grow at a constant rate. In order to use the equation to determine the current stock price, the current period’s dividend is typically multiplied by one plus the growth rate. Then it is divided by the required rate of return minus the growth rate.
Specific figures used with the dividend valuation model can vary, depending on factors such as company size and expected growth. On the other hand, earnings growth is typically expected to be constant. This is primarily because, if a growth rate is very high, it will usually only be able to sustain that level for a short period. If a growth rate is high for a while, it will usually drop eventually to what is known as a sustainable rate.
There are a few characteristics of the dividend valuation model which can complicate its use. It does not tend to work well with stocks that have a highly variable growth rate. The model is also less useful to companies that decide to drop the level of dividends, rather than the standard procedure of keeping them fairly level or raising them slightly. It does not tend to work well with companies that temporarily do not offer dividends.
The dividend discount model is the overall model from which the dividend valuation model equation is developed. It generates a future dividend which can then be discounted to determine a current value. This means the equation determines the net present value by anticipating future value and subtracting anticipated growth. The equation finds the stock value by dividing the dividend per share by the discount rate, minus dividend growth rate. As with dividends themselves, this model tends to keep value levels more constant than the stock market.