Dividends Versus Growth

The Discounted Dividend Model as

expressed in Equation 10.2 shows that,
other things held constant, a higher value
for D1 increases a stock’s price. However,
Equation 10.2 shows that higher growth
rate also increases the stock’s price.
Figure 10.2 Present Values of Dividends of a Constant Growth Stock
Where DG = $1.15, g = 8.3%, rs = 13.7%
• Dividends are paid out of earnings
• Therefore, growth in dividends requires growth in
earnings.
• Earnings growth in the long run occurs primarily
because firms retain earnings and reinvest them in the
business.
• Therefore, the higher the percentage of earnings
retained, the higher the growth rate.
ILLUSTRATION
Suppose you inherit a business that has $1,000,000 of
assets and no debt, thus $1,000,000 of equity. The
expected return on equity (ROE) equals 10.0%, so its
expected earnings for the coming year are
(0.10)(($1,000,000) = $100,000. You could take out the
entire $100,000 of earnings in dividends, or you could
reinvest some or all of the $100,00 in the business. If you
pay out all the earnings, you will have $100,000 of
dividend income this year, but dividends will not grow
because assets, and therefore earnings, will not grow.
However, suppose you decide to have the firm pay out 40%
and retain 60%. Now your dividend income in 1 Year will be
$40,000; but assets will rise by $60,000, and earnings and
dividends will likewise increase:

Next year’s earnings = Prior earnings + ROE (Retained Earnings)

= $100,000 + 0.1($60,000)
=$106,000

Next year’s dividends = 0.4 ($106,000) = $42,400

c
Moreover, your dividend income will continue to grow by
6% per year thereafter:

Growth Rate = (1 – Payout ratio) ROE

= (1 – 0.4) 10.0%

= 0.6 (10.0%) = 6.0%

This demonstrates that in the long run, growth in

dividends depends primarily on the firm’s payout ration
and its ROE.
Which is better: Current
Dividends or Growth?
A firm can provide a relatively high current dividend or
a high growth rate, BUT NOT BOTH.

Which would Stockholders prefer?

Some stockholders prefer current dividends while

others prefer a lower payout ratio and future growth.
• Empirical studies have been unable to determine which
strategy is optimal for maximizing a firm’s stock price.
• Dividend policy is an issue that the management must
decide on the basis of its judgment, NOT a mathematical
formula.
• Shareholders should prefer for the company to retain more
earnings if the firm has exceptionally good investment
opportunities.
• Shareholders should prefer a high payout if investment
opportunities are poor.
Required Conditions for the
Constant Growth Model
• First, the required rate of return, rs ,must be greater
than the long-run growth rate, g.

• Second, the constant growth model as expressed in

Equation 10.2 is not appropriate unless a company’s
growth rate is expected to remain constant in the
future. This condition almost never holds for the new
start-up firms, but it does exist for many mature
companies
Note that Equation 10.2 is sufficiently general to handle
the case of a zero growth stock, where the dividend is
expected to remain constant over time. If g = o, Equation
10.2 reduces to Equation 10.5

Equation 10.5
Valuing Nonconstant
Growth Stocks
• For many companies, it is not appropriate to assume
that dividends will grow at a constant rate.
• Most firms go through life cycle where they experience
different growth rates during different parts of the cycle.
• In their early years, most firms grow much faster that
the economy as a whole; then they match the
economy’s growth; and finally they grow slower than the
economy.
• Automobile manufacturers in the 1920s, computer software
firms such as Microsoft in the 1990s, and Google in the
2000s are examples of firms in the early part of their cycle.
• These firms are defined as supernormal, or nonconstant,
growth firms.

Supernormal (Nonconstant) Growth

• The part of the firm’s life cycle in which it grows much
faster that the economy as a whole.
Figure 10.3 Illustrates nonconstant growth and compares it with
normal growth, zero growth, and negative growth.
Because Equation 10.2 requires a constant growth rate,
we obviously cannot use it to value stocks that are not
growing at a constant rate. However, assuming that a
company currently enjoying supernormal growth will
eventually slow down and become a constant growth,
we can combine Equation 10.1 and 10.2 to construct a
new formula, Equation 10.6, for valuing the stock.
Equation 10.6
• First, we assume that the dividend will grow at a
nonconstant rate (generally a relatively high rate) for N
periods, after which it will grow at a constant rate, g. N is
often called horizon, or terminal, date.
• Second, we use the constant growth formula, Equation
10.2, to determine what the stock’s horizon, or continuing,
value will be N periods from today:
Horizon (Terminal) Date

• The date when the growth rate becomes constant. At this date, it is no longer
necessary to forecast the individual dividends.

Horizon (Continuing) Value

• The value at the horizon date of all dividends expected thereafter.

To implement Equation 10.6, we go through
the following three steps:

1. Find the PV of each dividend during the period of

nonconstant growth and sum them
2. Find the expected stock price at the end of the
nonconstant growth period. At this point it has become a
constant growth stock, so it can be valued with the
constant growth model. Discount this price back to the
present.
3. Add these two components to find the stock’s intrinsic
value.
Figure 10.4 Finding the value of the Nonconstant Growth Stock