This is the fourth installment of Money Q&A’s first ever blog series, Killer Stock Characteristics.
Be Sure To Check Out The Previous Killer Stock Characteristics
Today, we’ll look at how you can use a company’s dividend growth rate in order to found out approximately how much its stock price can expect to grow as well.
Why Does A Company’s Dividend Growth Rate Matter?
I love dividend paying stocks. They pay you to wait on their share prices to grow with dividends. A company’s dividend growth rate is a good proxy for how much their share price should also grow. As I’ve stated time and time again, a company’s share price is the present value of all its future cash flows (dividends) according to classic finance theory. So, a simple way to look at it is that a company who is increasing its dividends by 3% to 5% each year should see its share price of its common stock growing at approximately the same rate.
To give you an example, let’s look at one of my favorite companies, Coca-Cola (Stock Symbol: KO). In 2002, the Coca-Cola company issued a quarterly dividend of 20 cents or 80 cents per year. The share price of Coke at that time was right at about $50. Over the past ten years, Coca-Cola’s dividend has increased to 51 cents per quarters or $2.04 per year. That is a 10% annual increase in their dividend. Currently, Coca-Cola’s stock price has risen to $76 this year. That actually equates to only a 4% annual rise in the price of their stock. Of course, that rise hasn’t been on a straight line but ebbs and flows with the macro economy as well.
Stock Valuation Method Using The Dividend Discount Model
The dividend discount model values the price of a company’s stock by using predicted future dividends and discounting them back to present value and including their growth rate and the expected return as well. The model uses the variables of the company’s dividend growth rate in perpetuity, the cost of equity or required rate of return, and the dividend price in order to determine what the stock’s current share price should be.
To continue with the earlier example of Coca-Cola, you can find its share price by plugging in certain inputs into the dividend discount model’s formula. Coke’s dividend is $2.01, its dividend growth rate is 10%, and you can plug in a required rate of return of 12% into the formula. Using those inputs, you could expect Coca-Cola’s share price to be worth $100.50 ($2.01 / 12% – 10%).
Be sure to check out the next edition of the Money Q&A Blog Series, Killer Stock Characteristics, where I’ll talk about using a company’s return on equity (ROE) and return on assets (ROA) to find a great undervalued stock price.
Don’t Miss The Other Killer Stock Characteristics In The Series
As always, I’d love to hear your thoughts, comments, questions, or suggestions. Please feel free to shoot me an email Hank [at] MoneyQandA.com.