Valuing a Company Through Dividends

We can value a company by the dividends that it pays. One dividend method is for a company with constant dividends. Constant dividends mean the company pays the same dividend every single year. In other words, the dividend never grows.

Example – Constant Dividends 

“Tony’s Ribs pays an annual dividend of $2 per share. We want to earn an annual return of 10% on our investment.” 

We’re trying to identify what the share price should be for Tony’s Ribs. The formula for a constant dividend is as follows: 

Stock Price = Annual Dividend / Expected Rate of Return 

We take the $2 dividend and divide it by the 10% expected return, which is $20. We should be willing to pay $20 per share to purchase Tony’s Ribs. In other words, if we invested $20 and we got a 10% return, that would be a payment of $2. 

Example – Growth Dividends 

Now let’s look at an example where the dividends grow over time. This method is known as the Gordon Growth Model or the Dividend Discount Model. 

“Tony’s Ribs currently pays an annual dividend of $2 per share. We want to earn an annual return of 10% on our investment. The company grows at 5% per year.” 

The formula for dividends that grow each year is as follows: 

Stock Price = Annual Dividend One Year From Now / (Expected Return – Growth Rate) 

The dividend of $2 is going to grow at 5% per year. For our numerator, we need to calculate what the $2 dividend will be in one year. We take the $2 and multiply it by 1.05. In one year, the dividend will be $2.10. 

In the prior question, we just divided the dividend by the 10% required return, but that’s because there wasn’t a growth rate. Here, there is a growth rate of 5%. 

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.