Investment strategy revealed: How to calculate a share’s value using its future dividends

Julie Brownlee, Fsp Invest, 22 Jan. 2015

Tags: gordon’s growth model, dividend discount model, valuing shares, how to value shares, investment strategy, using dividends to value a share,

If you want to value a company, particularly a mature one that pays a stable dividend, then there’s a great way to do it.

You can use the Gordon’s growth model, otherwise known as the dividend discount model.

So how can you calculate the Gordon’s growth model? And what types of companies does it work best for?

Read on to find out…

The ins and outs of the Gordon’s growth model

The Gordon’s growth model is a simple yet power way of valuing shares using a company’s future dividends.

It works like this…

To value a share, you need:

  • A forecast for the next year’s expected dividend per share;
  • The expected growth of dividends over the long run; and
  • The investor’s required return.

Once you have this information, you can calculate the Gordon’s growth model by doing the following:

Gordon’s growth model: Next year’s expected dividend per share /
(the investor’s required return – the long-term dividend growth rate)

Let’s take a look at how this works with the help of an example…

Company ABC looks set to pay a dividend of 10c a share. The long-term growth rate of dividends is 4%. And an investor wants a return of 8%.

The value of a share to the investor is 250c (10c/(8%-4%).

How best to use the Gordon’s growth model

The Gordon’s growth model works best for certain types of companies. These companies should be mature, such as a tobacco company, and have steady and predictable dividends.

It won’t work for companies that don’t pay dividends.

It also won’t work for companies that are expected to show high rates of growth in their dividend payments over the next few years. That’s because the dividend growth rate will most likely be higher than the investor’s required return.

So there you have it, how to calculate a share’s value using its future dividends.

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