The Growth Rate of Dividends
- In the Dividend Discount Model, the current dividends have high importance, however the growth rate of those dividends over time emerges as vital in creating the value of the stock. The model calculates the value of a stock equals the dividend per share divided by the discount rate minus the dividend growth rate.
- Analysts examine the past five years and try to project out three to five years with a terminal value attached. The terminal value is the value of an investment at the end of a period, taking into account a specific rate of interest.
- The current laws require double taxation on corporate profits and dividends paid to the shareholder. Due to this, many businesses have ceased paying out dividends. Without dividends, the Dividend Discount Model needed to evolve. Now analysts examine a Discounted Cash Flow Model. This model examines all profits from the business and projects the future cash flows and discounts them back to today’s value. Most analysts will only examine the operating cash flow and disregard financing cash flows and investing cash flows, as the operating cash flows create the recurring profits.
- Investors buy investments to get a return. Dividends or capital gains are the two ways to get that return. Capital gains are considered more speculative and similar to gambling, whereas dividends are considered more conservative and consistent. A fixed-rate dividend has similarities to a bond where the bond issuer promises to pay the investor a fixed-rate interest payment.
- In a strong bull market, dividend-paying securities will lag the market and look too conservative. In a bear market, dividend-paying investments will perform better than the market. Prudent investors buy into a strong company and learn to be patient through the good times and the bad. Reinvesting growing dividends provides a compound effect to the investment, creating real wealth growth.