The Dividend Growth Model Assumes That Dividends Increase at a Constant Rate Forever: What You Need to Know

Have you ever wondered why some investors seem laser-focused on dividends while others care more about capital gains? The secret to understanding this behavior lies within the Dividend Growth Model (DGM), a formula that paints a compelling picture of how dividends can fuel long-term portfolio growth. But is it all that simple?

Let me take you on a journey to uncover the intricacies behind this model and explore why it has captured the attention of investors for decades. We'll dissect how the DGM assumes dividends will increase at a constant rate forever—a bold assumption, to say the least. We’ll also explore its practical application, limitations, and why some investors swear by it, while others dismiss it as too idealistic.

What is the Dividend Growth Model (DGM)?

The Dividend Growth Model, at its core, is a mathematical formula used to determine the value of a stock based on the dividends it pays and the growth of those dividends over time. It's an extension of the Gordon Growth Model, named after Myron Gordon, who popularized it.

The equation is quite simple, but its implications are profound:

$P=\frac{D_0(1+g)}{r-g}$P=r−gD0​(1+g)​

Where:

• $P$P is the price of the stock today.
• $D_0$D0​ is the dividend that was just paid.
• $g$g is the expected constant growth rate of the dividends.
• $r$r is the required rate of return for the investment.

Essentially, the DGM tries to calculate the present value of all future dividends that a stock is expected to pay. It assumes that dividends will grow at a constant rate forever, hence the "growth" in the name.

Breaking Down the Formula

• Dividends (D0): This is the backbone of the model. If a company pays a dividend, it’s essentially giving back a portion of its earnings to its shareholders. Dividends are seen as a tangible return, whereas capital gains are speculative—dependent on stock price movements.

• Growth Rate (g): This is where things get interesting. The model assumes that dividends will grow at a constant rate indefinitely. But what if the company hits a rough patch, or the industry faces disruption? This is where the model often faces criticism, and we'll dive deeper into these issues shortly.

• Required Rate of Return (r): This represents the investor's desired return on investment. It varies based on risk tolerance, interest rates, and market conditions. If the required rate of return is too high compared to the dividend growth rate, the stock price calculated by the DGM could appear undervalued.

The simplicity of the model is what makes it so attractive. Investors only need to input three variables to determine whether a stock is worth buying.

Does Dividend Growth Really Stay Constant Forever?

This is the elephant in the room. Can dividends really increase at a constant rate forever? The short answer is no. Companies are subject to economic cycles, competitive pressures, and changes in consumer preferences. All of these factors affect a company's ability to sustain and grow dividends.

Many companies experience periods of fluctuating profitability. During good times, dividends may soar, and in bad times, they may be cut altogether. Take, for example, General Electric (GE), which was once known for its consistent dividend payments. The company’s financial struggles eventually forced it to cut its dividends, much to the disappointment of dividend-focused investors.

However, the DGM’s assumption of constant dividend growth isn't entirely baseless. Some companies, often referred to as “Dividend Aristocrats,” have managed to grow their dividends for decades without interruption. These are typically well-established firms with strong cash flows and a proven business model.

Practical Application of the Dividend Growth Model

Despite its flaws, the DGM remains a popular tool for valuing stocks, particularly among income investors who prioritize dividends over capital gains. It’s especially useful when analyzing mature, stable companies that have a history of paying and increasing dividends.

For example, companies in industries like utilities, consumer staples, and healthcare are often good candidates for the DGM because their earnings are relatively predictable, and they tend to return a significant portion of those earnings to shareholders.

Here’s an example of how the DGM can be applied:

Let’s say you’re analyzing Coca-Cola (KO), a Dividend Aristocrat that has consistently raised its dividend for over 50 years. You want to determine if it’s a good investment based on its current dividend of $1.64 per share, a required return of 8%, and an expected dividend growth rate of 5%.

Using the DGM formula, we calculate:

$P=\frac{1.64(1+0.05)}{0.08-0.05}=\frac{1.64\times 1.05}{0.03}=\frac{1.722}{0.03}=57.40$P=0.08−0.051.64(1+0.05)​=0.031.64×1.05​=0.031.722​=57.40

Based on the DGM, the fair value of Coca-Cola’s stock is $57.40. If the current market price is lower than this, it might be considered undervalued, and vice versa if it's higher.

Limitations of the Dividend Growth Model

No financial model is perfect, and the DGM is no exception. One of its major drawbacks is the assumption that dividends will grow at a constant rate forever. This is highly unrealistic for most companies. Even those that have a strong track record of increasing dividends can face unexpected challenges that disrupt their growth trajectory.

Additionally, the DGM is sensitive to small changes in the growth rate (g) and the required rate of return (r). If these inputs are slightly off, it can lead to a significant over- or undervaluation of a stock. In fact, some critics argue that the DGM is too simplistic to be relied upon for serious investment decisions.

Another limitation is that the model only works for companies that pay dividends. Many high-growth companies, especially in the technology sector, choose to reinvest their earnings into growing the business rather than paying dividends. As a result, the DGM can’t be applied to these stocks, which makes it less useful for investors who are focused on growth rather than income.

Dividend Growth vs. Capital Gains: Which is Better?

The DGM inherently favors dividend-paying stocks, which raises an important question: Is focusing on dividends a better strategy than aiming for capital gains? The answer depends on your investment goals.

If you’re looking for steady, reliable income, dividend-paying stocks can be an excellent choice. Companies with a history of growing dividends tend to be well-established and financially stable, which can provide peace of mind during volatile markets.

On the other hand, if your goal is to maximize long-term capital appreciation, focusing on growth stocks might be more suitable. These companies typically reinvest their earnings to fuel further growth, which can lead to substantial increases in stock price over time. However, growth stocks are generally riskier and more volatile than dividend stocks.

Why Some Investors Love the Dividend Growth Model

Despite its limitations, the DGM has a loyal following among income investors, particularly those nearing or in retirement. These investors value the model's focus on dividend income, which can provide a reliable source of cash flow during retirement.

Additionally, dividend growth stocks tend to outperform non-dividend-paying stocks over the long term. According to research by Ned Davis Research, from 1972 to 2019, companies that consistently grew their dividends delivered an average annual return of 13.2%, compared to just 7.3% for non-dividend-paying stocks.

This historical performance, coupled with the peace of mind that comes from receiving regular dividend payments, makes the DGM an appealing tool for those who prioritize income over capital appreciation.

Conclusion: Is the Dividend Growth Model Right for You?

The Dividend Growth Model is a simple yet powerful tool for evaluating dividend-paying stocks. Its assumptions of constant dividend growth may not hold true for every company, but for stable, mature firms with a long history of increasing dividends, it can provide valuable insights into whether a stock is fairly valued.

However, it’s important to recognize the model’s limitations and use it as just one part of your overall investment strategy. No single model can capture the full complexity of the stock market, and the DGM is no exception.

If you’re an income-focused investor who values dividends, the DGM can be a useful addition to your toolkit. But if you’re more interested in high-growth, non-dividend-paying stocks, you’ll need to rely on other valuation models to guide your investment decisions.

At the end of the day, the Dividend Growth Model is just that—a model. Like any financial tool, it’s only as good as the assumptions you put into it. So use it wisely, and don’t forget to keep an eye on the bigger picture.