While the dividend discount model is typically used for estimating the fair value of a dividend-issuing company, the formula can be rearranged to back solve for the implied dividend growth rate, instead.
The simplest variation of the dividend discount model is the Gordon Growth Model, which assumes that dividends are anticipated to grow indefinitely at a constant rate.
The Gordon Growth Model approximates the share price of a company by taking the next period’s dividend per share (DPS) and dividing it by the required rate of return minus the dividend growth rate.
Gordon Growth Model (GGM) = Next Period Dividends Per Share (DPS) ÷ (Cost of Equity – Dividend Growth Rate)
Since all variations of the dividend discount model treat dividend issuances as the cash flows of the company, the appropriate discount rate — i.e. the required rate of return — is the cost of equity (ke), which represents solely equity shareholders.
Normally, the formula above would be used to predict a company’s share price and to decide whether its shares are undervalued (or overvalued).
But we’ll do the reverse here in order to calculate the dividend growth rate, where we divide DPS by the current share price and subtract that amount from the cost of equity.
Implied Dividend Growth Rate = Cost of Equity – (Dividends Per Share ÷ Current Share Price)
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We’ll now move to a modeling exercise, which you can access by filling out the form below.
Implied Dividend Growth Rate Calculation Example
Suppose a company is trading at a share price of $40.00 as of the current date.
The expected dividend per share (DPS) next year is $2.00 and the cost of equity, i.e. the required rate of return for shareholders, is 10.0%.
Current Share Price = $40.00
Expected Dividend Per Share (DPS) = $2.00
Cost of Equity (ke) = 10.0%
Given those set of assumptions, we’ll calculate our implied growth rate by taking dividing our DPS ($2.00) by the current share price ($40.00) and then subtracting it from the cost of equity (10.0%).
We arrive at an implied growth rate of 5.0%, which we would then compare to the growth rate embedded in the current market share price to determine if the company’s shares are undervalued, overvalued, or priced near their fair value.
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