The Gordon dividend growth model

Gordon dividend growth model part 1

The dividend growth model is one of the earliest, if not the earliest, ways of valuing a stock. I might do a post on the derivation of this formula, but I shall skip that for now.

This is the formula:

Market price (P) = d / (r - g)

D is the current dividends or last dividends declared by the company. It is in dollar terms. R is the expected return that you are aiming for when you purchase the stock. I assume a 7% for illustrative purpose. Lastly, g is the dividend growth rate. We can use historical rates or predict it. I use 5% for this. Assume the company has just paid out a dividend of $0.20 per share, in order to get a 7% return, I would need to purchase this stock below $10.

$0.20 / (7% - 5%) = $10.

This gives us a way of valuing a stock, of knowing whether it is a reasonable price to pay. However, the beauty of this formula is that it can be rearranged to form another more elegant equation (elegant in my own definition as beauty is in the eyes of the beholder).

Gordon dividend growth model part 2

Rearragement:

P = d / (r - g)
P (r - g) = d
r - g = d/P
r = d/P + g

In other words,

Expected return = dividend yield + dividend growth rate

This means that I can have a reasonable estimate of how the market will move in the long run. The US market has given us a return of 10% in the past. This is made up of 2% in dividend yield, and 7% in capital appreciation. Do note that capital appreciation is the number as dividend growth rate as stock price must move at the same rate as dividend growth for dividend yield to remain constant.

2% + 7% = 9%. Where does the 1% come from? According to John Bogle, founder of the Vanguard group and advocate of Index Investing, this 1% is called a speculative return which comes about due to emotions, where heavy buying causes it to be a positive number and vice versa. It will always revert to the mean.

Applying it

I prefer to apply the model in a more macro level, on a country scale. In light of this, the Singapore market is currently selling at 3% dividend yield. I assume the dividend growth rate to be 5%. The number is easy to get, as it is usually the economic growth rate of a country. For a stock, it is the earnings growth of a company. With this, the expected return will be 8% in the long run (3% + 5% = 8%).
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Relac 1234
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24 February 2016 at 13:06 delete

The economic growth rate for Singapore as a almost matured economy in the long term will be like 2% of US if we are lucky (as Singapore is not as innovative as US in generating new engines of growth).
http://www.tradingeconomics.com/united-states/gdp-growth
Hence, more likely to be 3% + 2% = 5% as the expected return.

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24 February 2016 at 15:55 delete

Yes agree with you that Singapore GDP growth is going to be low like that of the US. Both Singapore and US had high returns in the past as both were considered developing economies, and thus were more risky giving higher returns. I would be satisfied with 5% return knowing that most investors would not be able to get this return.

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