Dividend Growth Model: A Method of Valuation of a Company’s Share Price

Dividend Growth Model:
The dividend growth model is a method of valuation of a company’s share price. It is a popular
method and assumes that the current theoretical price of a share is equal to the worth of the
present value of the sum of all the future dividend payments flow from the share till perpetuity
(Investopedia, n.d.). In other words, the present value of a share should ideally be equal to the
present value of all the future dividends put aggregated. The theory was proposed by Myron J.
Gordon and also popularly known as Gordon growth model. It was first proposed by Mr. Gordon in
his book Eli Shapiro in 1956. The entire concept can be depicted in the form of a simple formula
which is as follows:
P = D1 / (r - g)
Where:
 P is the theoretical value of the share
 D1 is the expected payment of dividend to be made at time t = 1;
 ‘g’ is the rate at which the dividend is expected to grow; and
 ‘r’ is required rate of return by the investor
(Vaidya, n.d.)
The dividend discount model can be further interpreted based on the assumption we take on the
growth rate of the company. Some sub-models with in the dividend discount model based on
different assumptions of growth rate are as follows:
Dividend Discount Model – Constant Growth Rate
In this model, our assumption regarding the growth rate of the dividend is that it will remain
constant. This is the basic version of dividend discount model and the formula is same as above.
Dividend Discount Model – 2 stage growth approach:
In this approach, we assume that there are 2 stages of growth for the dividend. The first stage being
abnormal growth followed by a second and ultimate stage of constant growth. This approach is
more relevant in case of the companies which are newly incorporated and which experience
abnormal growths in the growth phase of the company and finally becomes constant when the
company reaches maturity phase.
Dividend Discount Model – Multi-stage growth approach:
This is a developed version of 2 stage growth approach and have more practical approach in
treatment of growth rate. In this approach, we assume that there are many stages for growth of
dividend and finally at some point of time the dividend growth rate becomes constant as the
company reaches maturity phase (Accountingexplained.com, n.d.).
Relevant Model for valuation in given situation
Since multiple growth rates were given the company should adopt multi-stage growth approach in
valuation of its shares.
The theoretical value of share in the given situation is computed as follows:
Dividend D0 => Earnings per share x Pay-out ratio = $1.50 x 30% =$0.45
Required Rate of return = 12% and