Dividends per share (DPS) measures the total amount of profits a company pays out to its shareholders, generally over a year, on a per-share basis. DPS can be calculated by subtracting the special dividends from the sum of all dividends over one year, and dividing this figure by the outstanding shares. For example, company HIJ has five million outstanding shares and paid dividends of $2.5 million last year; no special dividends were paid. The DPS for company HIJ is 50 cents ($2,500,000 ÷ 5,000,000) per share. A company can decrease, increase, or eliminate all dividend payments at any time.
A company may cut or eliminate dividends when the economy is experiencing a downturn. Suppose a dividend-paying company is not earning enough; it may look to decrease or eliminate dividends because of the fall in sales and revenues. For example, if company HIJ experiences a fall in profits due to a recession the next year, it may look to cut a portion of its dividends to reduce costs.
Another example would be if a company is paying too much in dividends. A company can gauge whether it is paying too much of its earnings to shareholders by using the payout ratio. For example, suppose company HIJ has a DPS of 50 cents per share and its earnings per share (EPS) is 45 cents per share. The payout ratio is 111% (0.50 ÷ .45); this figure shows that HIJ is paying out more to its shareholders than the amount it is earning. The company will look to cut or eliminate dividends because it should not be paying out more than it is earning.
The Dividend Discount Model
The dividend discount model (DDM), also known as the Gordon growth model, assumes a stock is worth the summed present value of all future dividend payments. This is a popular valuation method used by fundamental investors and value investors. In simplified theory, a company invests its assets to derive future returns, reinvests the necessary portion of those future returns to maintain and grow the firm, and transfers the balance of those returns to shareholders in the form of dividends. According to the DDM, the value of a stock is calculated as a ratio with the next annual dividend in the numerator and the discount rate less the dividend growth rate in the denominator. To use this model, the company must pay a dividend and that dividend must grow at a regular rate over the long-term. The discount rate must also be higher than the dividend growth rate for the model to be valid.
The DDM is solely concerned with providing an analysis of the value of a stock based solely on expected future income from dividends. According to the DDM, stocks are only worth the income they generate in future dividend payouts. One of the most conservative metrics to value stocks, this model represents a financial theory that requires a significant amount of assumption in regard to a company’s dividend payments, patterns of growth, and future interest rates. Advocates believe projected future cash dividends are the only dependable appraisal of a company’s intrinsic value.
The DDM requires three pieces of data for its analysis, including the current or most recent dividend amount paid out by the company; the rate of growth of the dividend payments over the company’s dividend history; and the required rate of return the investor wishes to make or considers minimally acceptable.
The current dividend payout can be found among a company’s financial statements on the statement of cash flows. The rate of growth of dividend payments requires historical information about the company that can easily be found on any number of stock information websites. The required rate of return is determined by an individual investor or analyst based on a chosen investment strategy.
While the dividend discount model provides a solid approach for projecting future dividend income, it falls short as an equity valuation tool by failing to include any allowance for capital gains through appreciation in stock price.