Dividends

Cash dividends

Common stock investors are eligible for cash dividends from the stock they own. Dividends are earnings that are passed on to stockholders. Companies are not required to pay dividends, and some companies never pay dividends.

A company’s business model determines if they pay dividends. Smaller, growing companies tend to avoid paying dividends, which allows them to retain their earnings and spend money on scaling (growing) the business. Larger, well-established companies often choose to pay dividends as their business and profits are already sizeable. Ultimately, a company’s Board of Directors (BOD) determines if a dividend will be paid.

Dividends are useful to investors because they provide a return on investment without having to sell the investment. They are especially helpful to investors who are retired and need income from their investments. Let’s take a look at a real-world example of Target in 2021, which is a dividend-paying company:

• March 10th - $0.68 per share dividend

• June 10th - $0.68 per share dividend

• September 10th - $0.90 per share dividend

• December 10th - $0.90 per share dividend

An investor owning 1,000 shares of Target stock throughout 2019 received $3,160 in dividends. Investors seeking income can purchase a number of shares in a dividend-paying company and collect those dividends over time.

In summary, cash dividends represent profits shared with common and preferred stock investors. Some common stocks pay dividends, while virtually all preferred stocks pay dividends (unless skipped). The amount paid and the growth* of the dividend can be analyzed to determine the value of a stock. We’ll discuss the models utilized to perform this analysis for the remaining portion of this chapter.

*Only common stock dividends tend to grow over time. Preferred stock dividends are typically fixed.

Dividend discount model

We’ll discuss time value of money in the analytical methods chapter, a concept very important to investors. A dollar received today is worth more than a dollar received in the future due to opportunity cost. The dividend discount model is a tool used by investors to determine the appropriate value (a.k.a. present value) of a stock based on future dividends paid while considering the time value of money.

American economist John Burr Williams (Ph.D.) is often credited with making the dividend discount model popular. In his book, The Theory of Investment Value, Dr. Williams argued the actual value of a stock was equal to the discounted value of all future dividends to be paid. As we’ve learned, dividends represent profits shared by a company with its shareholders. While an investor may attain capital appreciation, the only return a common or preferred stockholder realizes without selling their shares is dividend payments.

Series 65 test questions tend to focus on the concept of the dividend discount model and its relation to the time value of money. While unlikely, it’s possible to encounter a math-based test question on this topic. Numerous complex formulas exist in the real world, but here’s the only version of the calculation you may need to know:

$\text{Stock\hspace{0.33em}value}=\frac{\text{Annual dividend}}{\text{Discount rate*}}$

*As we will learn in the analytical methods chapter, the discount rate represents the average rate of return in the market. When discounting future cash flow back to present value, it’s important to be aware of the lost opportunity an investor faces when waiting to receive future cash flows. If the average rate of return in the market is 5%, then the investor is missing out on an average 5% return prior to receiving that cash flow. In some instances, test questions will refer to the discount rate as the required rate of return.

Let’s work through an example test question together:

An investor is considering the purchase of $100 par, 5% preferred stock currently priced at $120 per share. The average dividend yield in the market is 4%. What statement is true?

A) The stock is undervalued
B) The stock is overvalued
C) The stock is appropriately priced
D) The stock’s value cannot be determined

Think about it for a bit. The answer is detailed below:

Dividend growth model

Common stocks that pay dividends typically increase their dividend payments periodically. For example, Coca-Cola (KO) typically increases its dividend by one or two pennies per share on an annual basis. To value a stock with a growing dividend, the dividend growth model is oftentimes utilized. Popularized by another American Economist by the name of Myron Gordon (Ph.D.), this model is sometimes referred to as the Gordon growth model.

Dr. Gordon argued the value of a common stock with an increasing dividend could be calculated by tweaking the dividend discount model. While it’s very unlikely you encounter a test question on the formula, let’s work through some numbers to better understand this topic.

$\text{Stock value}=\frac{\text{Annual dividend}}{\text{Discount rate - dividend growth\hspace{0.33em}rate}}$

Let’s assume the following:

• Stock’s annual dividend = $7
• Discount rate = 6%
• Dividend growth rate = 2%

$\text{Stock\hspace{0.33em}value}=\frac{\text{\$7}}{\text{0.06 - 0.02}}$

$\text{Stock\hspace{0.33em}value}=\frac{\text{\$7}}{\text{0.04}}$

$\text{Stock\hspace{0.33em}value}=\text{\$175}$

If a stock has a $7 dividend while increasing its dividend by 2% annually and an average market return of 6%, its present value is $175. If the stock’s price is above $175, it’s overvalued. If the stock’s price is below $175, it’s undervalued.

The dividend growth model takes the dividend discount model a step further by assuming growth in a stock’s annual dividend. This calculation is necessary for stocks with increasing dividends, which is typical for dividend-paying common stocks. The model cannot be used for preferred stock because its dividend rate is fixed and does not change over time.