Founding Father and President Thomas Jefferson once said that compound interest is the most powerful force in the universe. When this logic applies to your investment portfolio using the dividend growth model, you unleash that power for yourself and your goals. In this article, we will explain to you what the dividend growth model is. You will also read about how it works, and how you can utilize it as a part of your investment strategy.
The dividend discount model or DDM posits that the worth of stock in a company is primarily determined by the present and future dividends the company will issue to the shareholder. With this in mind, a potential stockholder can discover whether a stock is worth putting into their basket of investments.
A Brief History of the Dividend Growth Model
In 1956, Myron Jules Gordon and Eli Shapiro introduced the dividend growth model in their paper Capital Equipment Analysis: The Required Rate of Profit. This paper was based on theories from John Burr Williams’ 1938 book The Theory of Investment Value.
The Gordon Model, as it became famous, is one of the oldest valuation methods for stocks and other investment tools. But how does that relate to what’s in your pocket book? In the following section, we’ll explore that further.
Puting the Dividend Growth Model to Work
In layman’s terms, a dividend growth model is a way to value stocks. You do this by looking at their history of dividend growth, their current dividend and the current price of the stock. You can find the true valuation of a stock using the Gordon dividend growth model. How? One simply divides the dividend payout ratio by your necessary rate of return (12%, for example). Then, one takes out the expected growth rate of that company’s dividends. You can find the dividend growth history using the information provided by an exchange website such as the NASDAQ or NYSE.
Two- and three-step dividend growth models also exist, and these can be used in different contexts when the Gordon Model is insufficient. The companies the dividend growth model work best for are firms with stable growth, particularly firms that specialize in financial service, regional utilities, and Real Estate Investment Trusts, or REITs.
Who Should Use the Dividend Growth Model?
When using the dividend growth model, an investor makes certain assumptions about a stock. This method also excludes factors such as the brand loyalty of a company, changes in leadership and the health of the overall financial sector.
Usage of the dividend growth model is ideal for investors who desire value over growth. But dividend growth model can be more than a valuation method. It can be a tool you can use to create or augment your portfolio.
4 Ways You Can Use a Dividend Growth Model
- A dividend reinvestment plan (or DRIP) can maximize your profit. Dividend reinvestment plans allow investors to buy fractional shares of a stock with dividends at a discount. By compounding the interest from dividends, your investment ends its life larger than it would have been through cash purchases alone. For example, REITs are mandated to pay out upwards of 95% of their income as dividends. In the field of REITs, scholarly evidence supports dividend pricing models as valuation methods.
- An investor can couple compounding interest with tax deferment. This is possible by coupling a dividend growth model with a Traditional or Roth IRA. Also, because these retirement plans are tax-deferred, they minimize the costs to the investor in the long-term. The dividends in a Roth IRA, in particular, grow tax-free, meaning that gains grow exponentially. This union of strategies can yield significant profits.
- When in an investor diversifies their portfolio, they minimize overall risk. This is by using the dividend growth model to pick dividend-disbursing value stocks in all ten sectors. One sector may be under-performing. However, the others will be matching or outperforming the major indexes. By picking assets that are balanced out by stocks in other sectors, the investor maximizes their portfolio’s growth potential.
- One easy way to diversify a portfolio is to buy Exchange Traded Funds, or ETFs. These assets are publicly traded like stocks, but offer the diversity of a mutual fund. These funds can be sector-based, strategy-based or even invest in government or corporate bonds. ETFs have different weightings. So, one can choose aggressive or conservative allocations they can tailor to their individual or familial needs.
In the End
Ultimately, the dividend growth model is perhaps the simplest way to find the valuation of a stock pick and can be beneficial to your net worth over the long haul. It is useful to know when you will be selling your stock. So, set a target date for when you will need the money, e.g. retirement, the time you want to start up a business, when your children will need to go to college, etc. But the dividend growth model can be more than a valuation method: it can be a tool you can use to create your portfolio. When you couple it with periodic cash additions from your investment pool, dividend growth passively grows your portfolio.
Using the dividend growth model, savvy investors can discern if a stock is selling at a discount. They can also see whether the stock’s value is high or low. By following the wisdom of Gordon, Shapiro, and Jefferson, investors can see that their assets will be safe for their retirement. So, call your financial adviser. Then, tell them you want your portfolio to utilize the dividend growth model to the fullest extent. Your pocketbook will thank you.
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