Dividend Growth Model: Unveiling the Components of Total Return

Understanding the dividend growth model is crucial for any investor looking to value a share of common stock. This model, while relatively simple, captures the essence of total return, which is the sum of capital appreciation and dividends. Let's delve into the intricacies of the model and explore the two key components that contribute to the total return.

Overview of the Dividend Growth Model

The dividend growth model, in its simplest form, can be derived from the growing perpetuity formula. According to this model, the total expected return from an investment in a share of common stock can be calculated using the following equation:

Estimate the total expected return: r g frac{D_1}{P}

Where:

r the total expected returng the growth rate of dividendsD_1 the dividend expected to be received exactly one period later from nowP the current price of each share of the stock

Exploring the Two Key Components

The two main components of the total return on a share of common stock as described by the dividend growth model are the growth rate of dividends (g) and the dividend yield (frac{D_1}{P}).

1. Growth Rate of Dividends (g)

The g component represents the expected future growth of the dividends. This is often used to project the cash flows from an investment and gives investors an idea of the potential long-term gains. It is particularly relevant for unicorns or high-growth companies, where the growth rate is expected to contribute a significant portion to the total return. For example, in the tech industry, many startups are valued based on their potential for high future growth, even if their current earnings are minimal.

2. Dividend Yield((frac{D_1}{P}))

The dividend yield component, which represents the current income that an investor can generate from holding the stock, is calculated as the dividend expected to be received divided by the current stock price. It is typically more relevant for mature companies where the focus is more on current income rather than future growth. For instance, in traditional sectors like utilities or dividend-paying banks, the dividend yield is a crucial metric as it provides a steady income stream to investors.

Differences in Contribution to Total Return

The contribution of these two components to the total return can vary significantly depending on the type of company being analyzed. For a unicorn, the potential for future growth (represented by g) is often higher, meaning the growth rate of dividends can play a more substantial role in the total return. Conversely, for a mature company, the current income stream (represented by (frac{D_1}{P})) is likely to be more significant.

Conclusion

In conclusion, the dividend growth model provides a valuable framework for understanding the total return on an investment in a share of common stock. The two key components, the growth rate of dividends and the dividend yield, each play crucial roles depending on the type of company being evaluated. While unicorns are often driven by future growth, mature companies tend to rely more on their current dividend payouts. Understanding these components can help investors make more informed decisions and align their investment strategies with their financial goals.