Cash 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 paid out to stockholders. Companies aren’t required to pay dividends, and some companies never do.

Whether a company pays dividends often depends on its business model.

• Smaller, fast-growing companies often avoid dividends so they can retain earnings and reinvest in expanding the business.
• Larger, well-established companies are more likely 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 selling the investment. This can be especially useful for investors who want ongoing income (for example, 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 who want income can buy shares of dividend-paying companies and collect 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 used 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

The time value of money is a key concept for investors. A dollar received today is worth more than a dollar received in the future because of opportunity cost - money you have now can be invested and potentially earn a return.

The dividend discount model estimates the appropriate value (the present value) of a stock based on its future dividend payments, 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’re the only return a common or preferred stockholder receives without selling shares (even though an investor may also earn capital appreciation).

Series 66 questions usually focus on the concept of the dividend discount model and how it connects to the time value of money. While it’s unlikely, you could see a calculation-based question. Many real-world versions of the model are more complex, but this is the version you may need to know:

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

*As you’ll see in the time value of money 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 opportunity cost of waiting. If the average market return is 5%, then receiving cash later means giving up an average 5% return until that cash arrives. Some test questions refer to the discount rate as 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 first, then check the solution below.

Dividend growth model

Common stocks that pay dividends often increase their dividend payments 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 dividend that grows, investors often 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 dividend-paying common stock with an increasing dividend by adjusting the dividend discount model. It’s very unlikely you’ll need to memorize this formula for the exam, but working through the numbers helps you see what the model is doing.

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

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 in the annual dividend. This is most relevant for dividend-paying common stocks. The model isn’t used for preferred stock because preferred dividends are typically fixed and don’t grow over time.