Dividends

Cash dividends

Common stock investors may receive cash dividends from the stock they own. Dividends are a portion of a company’s earnings that are distributed to stockholders. Companies are not required to pay dividends, and some companies never do.

Whether a company pays dividends often depends on its business model. Smaller, fast-growing companies typically avoid dividends so they can retain earnings and reinvest in scaling the business. Larger, well-established companies often choose to pay dividends because their operations and profits are already substantial. Ultimately, a company’s Board of Directors (BOD) decides whether a dividend will be paid.

Dividends matter to investors because they provide a return without requiring the investor to sell shares. This can be especially useful for investors who want ongoing income, such as retirees. Here’s a real-world example using Target in 2021 (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 buy shares of dividend-paying companies 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 help determine the value of a stock. We’ll cover the models used for this analysis in the rest of this chapter.

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

Dividend discount model

You’ll learn more about time value of money in the analytical methods chapter. For now, the key idea is this: a dollar received today is worth more than a dollar received in the future because of opportunity cost.

The dividend discount model is a tool investors use to estimate the appropriate value (present value) of a stock based on the future dividends it is expected to pay, while accounting for the time value of money.

American economist John Burr Williams (Ph.D.) is often credited with popularizing the dividend discount model. In his book, The Theory of Investment Value, Dr. Williams argued that the actual value of a stock equals the discounted value of all future dividends. Since dividends are profits shared with shareholders, they represent the only return a common or preferred stockholder receives without selling shares (even though an investor may also earn capital appreciation).

Series 65 questions tend to emphasize the concept of the dividend discount model and how it connects to time value of money. While it’s unlikely, you could see a math-based question. Many complex formulas exist in practice, but here’s the only version you may need to know:

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

*As you’ll see in the analytical methods chapter, the discount rate represents the average rate of return in the market. When you discount future cash flows back to present value, you’re accounting for the return an investor gives up by waiting. For example, if the average market return is 5%, the investor is giving up an average 5% return until that cash flow is received. Some test questions may call the discount rate the required rate of return.

Let’s work through an example test question:

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 it through, then check the solution below.

Dividend growth model

Dividend-paying common stocks often increase their dividends over time. For example, Coca-Cola (KO) typically increases its dividend by one or two pennies per share each year.

To value a stock with a growing dividend, investors may use the dividend growth model. Popularized by American economist Myron Gordon (Ph.D.), this approach is also called the Gordon growth model.

Dr. Gordon argued that you can value a common stock with an increasing dividend by adjusting the dividend discount model to include dividend growth. It’s very unlikely you’ll see this formula tested directly, but working through the numbers helps clarify the concept.

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

Let’s assume the following:

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

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

$\text{Stock value}=\frac{\text{\$7}}{\text{0.04}}$

$\text{Stock value}=\text{\$175}$

So, if a stock pays a $7 dividend, grows that dividend by 2% annually, and the average market return is 6%, the model estimates a present value of $175.

• If the stock’s market price is above $175, it’s overvalued.
• If the stock’s market price is below $175, it’s undervalued.

The dividend growth model extends the dividend discount model by building in growth of the annual dividend, which is common for dividend-paying common stock. The model isn’t used for preferred stock because preferred dividends are typically fixed and don’t change over time.