I’ve been devoting my stock research towards dividend stocks recently, or more specifically dividend growth stocks. I am focusing on companies that have a long history of increasing their dividends year after year. Over the long term companies that follow this policy often provide much greater income than other companies that for example may have a high yield currently but never increase their payout.

The vast majority of dividend growth stocks are large cap, well-established companies that are well past their high-growth phase. In fact, this is what allows them to pay dividends and increase them on a regular basis. The management of smaller high-growth companies are often able to achieve better returns by reinvesting earnings in the company, whether it be for plant expansions, new R&D, or marketing. Larger companies are obligated to pay back earnings to their owners (stockholders) in the form of dividends if ROI is too low for any internal investment options.

One of my favorite ways to determine the intrinsic value of a company is through EPS growth capitalization. It’s fast, easy to understand, and it works well under most circumstances. It works best however on companies that are priced for growth – the main inputs into this valuation method are an estimate of future PE and earnings growth. Dividend growth stocks by comparison certainly have earnings growth built into their share price, but more important is the dividend yield and *dividend growth*. Dividends don’t factor into the EPS growth capitalization method at all (directly), so today I am going to explain the use of another stock valuation method called the *Dividend Discount Model* (DDM), which is used specifically for dividend growth stocks.

It’s a very simple equation as follows:

**IV = D / (r – g)**

where:

- IV = Intrinsic Value of the stock
- D = Current annual dividend
- r = Discount rate (%)
- g = Dividend growth rate (%)

The intrinsic value is what we’re trying to determine. Once calculated, we can compare it to the current trading price of the stock and determine whether the company is trading at fair value or whether it is over/underpriced. The current annual dividend is simply found from any stock data website such as Guru Focus. The remaining two parameters in the denominator of the equation require a bit more explanation.

**Discount rate**: The discount rate is technically the cost of equity for the company, but in simpler terms it can be thought of as the minimum acceptable rate of return (MARR) that we are willing to accept for this investment. Typically this number ranges between 9 – 15%. I use 9% for large, solid “safe” companies, and numbers closer to the 15% range for riskier investments. It should be noted that this number has a huge impact on the results of the evaluation, particularly when it is close to the dividend growth rate.

**Dividend growth rate**: This is the annual growth rate of the company’s dividend as a percentage. For example, a company that paid a $1.00 annual dividend last year and increased it to $1.10 this year would have a 10% dividend growth rate for this year. Rather than simply use last year’s rate though, I prefer to look at how the dividend has increased over time. I look at the 10-yr, 5-yr, 3-yr, and 1-yr compound annual growth rates (CAGR) and either choose the lowest or use an average as my input into the “g” term in the equation. I’ve recently written an article on how to calculate CAGR if you’re unfamiliar with how to do so.

## DDM Example

To make sure this is all perfectly clear, let’s look at an example using an excellent dividend growth stock: Chevron (CVX). This company has a history of increasing its dividend every year for the past 25 years.

- Chevron is currently paying an annual dividend of $3.60 and is currently trading at around $118/share for a yield of 3%.
- Chevron is a large, well-established company, but is still growing earnings at 8 – 9% / year. I am going to use a middle of the road discount rate of 12% in this case.
- Dividend CAGRs for the past 5, 3, and 1 years are 9.2%, 9.7%, and 13.6% respectively. To be conservative we will choose the lowest: 9.2%

Feeding these into our equation we determine Chevron’s intrinsic value:

**IV = $3.60 / (0.12 – 0.092) = $128.57**

Today CVX closed at $117.52, which is about 8.5% lower than the intrinsic value we calculated above. Based on this, it would appear that CVX is slightly undervalued at the moment, however it’s important to use a healthy margin of safety (MOS) to cover any uncertainty in the assumptions made.

Hi Dustin

Thanks for a very clear explanation of DDM. What margin of safety would you use and would you consider factors such as market cap, peer to peer analysis etc?

Thanks

David