Dividend stocks have a long track record as excellent investments, whether you are looking to grow your wealth or want a steady source of income. But paying a dividend is only the start: The best dividend stocks are the companies that can deliver dividend growth over many years, and even decades.
But sometimes just picking a dividend stock, buying it, and hoping for the best isn't good enough. For investors willing to invest a little bit more time, and wanting to make sure they buy dividend stocks that will meet their expectations, doing dividend growth homework can go a long way. In other words, you should do some modeling to determine if a stock will meet your long-term dividend expectations and if the price you're paying is reasonable.
Let's take a closer look at dividend growth modeling and how it can help you invest better.
What is the dividend growth model?
The dividend growth model is a mathematical formula investors can use to determine a reasonable fair value for a company's stock based on its current dividend and its expected future dividend growth. The basic formula for the dividend growth model is as follows:
Price = Current annual dividend ÷ (desired rate of return - expected rate of dividend growth)
This formula can be a helpful tool to determine what a fair price for a stock would be based on different potential outcomes. However, investors must understand that a lot of assumptions go into a modeling tool like this one. For instance, one common practice is to use a company's recent historical dividend growth as the expected rate of future growth, and that may or may not work out in reality.
A recent real-world example of this method leading to very different outcomes: the case of Coca-Cola (NYSE:KO) and Wells Fargo (NYSE:WFC). From 2015 to 2019, Wells Fargo increased its dividend more than twice as much as Coca-Cola:
At the beginning of 2020, both companies' stocks traded for similar prices, between $53 and $55 per share, while Wells Fargo paid the higher dividend and had the higher recent dividend growth rate.
Then the coronavirus pandemic and global recession happened. Wells Fargo has struggled, and it was forced by regulators to slash its dividend to preserve capital, while Coke has held up relatively well in comparison:
The lesson: In reality, assumptions don't always work out, and often for reasons you simply cannot foresee (like a global pandemic). As a result, the dividend growth model can be a handy tool for working through various scenarios -- including those involving low returns -- but it's not a substitute for building a diversified portfolio of companies that aren't exposed to the same kinds of economic or industry-specific risks.
This example is also a reminder that dividend growth models work best with companies like Coca-Cola, a Dividend Aristocrat that's increased its dividend every year for almost six decades.
Other dividend models
While using the dividend growth model can be a handy way to work through various scenarios to determine if a stock's current price represents a fair value, there are other formulas you can use to model the value of a company's future cash flows. These are often used with a cost-of-capital adjustment to discount the value of those future cash flows.
The Gordon growth model
The Gordon growth model is a means of valuing a stock based entirely on a company's future dividend payments. This model makes some assumptions, including a company's rate of future dividend growth and your cost of capital, to arrive at a stock price.
Again, the number the formula generates is entirely the product of a company's future expected dividends, giving no weight to a company's other assets or its ability to generate capital growth. While this certainly has limitations, it can make the Gordon growth model a handy tool for investors looking specifically at dividends as a source of reliable income.
Variations on the Gordon growth model
Two common variants that do the same thing -- value a stock entirely according to future dividends -- are the one-period dividend discount model and the multiperiod dividend discount model. While the Gordon growth model is a simple formula for valuing a stock based on future dividends after adjusting for the cost of capital, these two variants apply a more complex formula to value dividends over a specific period.
Dividend modeling can be helpful for valuing a stock, but it's heavily influenced by assumptions
There are the calculations, and there's what happens in the real world. In other words, don't get too caught up in trying to be precise with your modeling; the extra time you invest in trying to get perfect calculations won't improve the end result in the real world.
A better approach is to hedge toward being conservative with your projections. The more optimistic your expected rates of dividend growth, the higher the "fair value" you will arrive at; if a company fails to deliver on your expected future dividend growth, your future returns could be affected. The biggest lesson: Be conservative in your expectations, and accept the fact that your modeling is only a helpful part of the broader framework that makes up your investing strategy.