Valuing a Company Through Dividends

Kyle Ashcraft, CPA · 2019 CPA Exam Scores · 95 FAR · 98 BEC · 91 REG · 90 AUD

One way to value a company is by the dividends it pays out. Which formula you use depends on a single question: does the dividend stay flat, or does it grow every year?

How do you value a company with a constant dividend?

If a company pays the exact same dividend every year — it never grows — the formula is simple:

Stock Price = Annual Dividend ÷ Expected Rate of Return

Say Tony's Ribs pays a $2 annual dividend, and you want a 10% annual return on your investment:

Stock Price = $2 ÷ 10% = $20 per share

The logic runs both directions: if you paid $20 and earned a 10% return, that return would be exactly $2 — the dividend you were promised.

How do you value a company with a growing dividend?

When the dividend grows every year, use the Gordon Growth Model (also called the Dividend Discount Model) instead:

Stock Price = Next Year's Dividend ÷ (Expected Return − Growth Rate)

Say Tony's Ribs currently pays a $2 annual dividend, growing 5% per year, and you still want a 10% return. First, project the dividend forward one year:

Next year's dividend = $2 × 1.05 = $2.10

Then divide by the gap between your required return and the growth rate — 10% minus 5%, or 5%:

Stock Price = $2.10 ÷ 5% = $42 per share

A growing dividend is worth more per dollar of current payout than a flat one. Tony's Ribs pays out the same $2 today in both examples, but the growing version is worth more than twice as much ($42 vs. $20) — because you're not just buying this year's dividend, you're buying every larger dividend that follows it.

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Kyle Ashcraft, CPA scored 90 or above on every section of the CPA exam in 2019, including a 98 on BEC. He is the founder and sole instructor of Maxwell CPA Review, a complete CPA review course covering all six sections, where he creates every lecture, textbook and study outline himself.

Therefore, we’re going to divide the numerator by the expected rate of return of 10% minus the growth rate of 5%. Therefore we divide $2.10 by 5%, which equals $42 per share. We should be willing to pay $42 per share.