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Definition of Dividend Valuation Model

In the valuation sections of the series 65 or series 66 exams, the dividend valuation model frequently appears to challenge test takers. The dividend valuation models look at the future cash flow generated by the dividend in order to determine what price an investor would or should pay for a stock.

Applying "Dividend Valuation Model" to Securities Exams:

When taking the series 65 or 66 exams you will most likely see a question that relates to the dividend valuation model and the dividend growth model. The question will most likely ask you about which one of these models would result in a higher current stock value? The answer is, the dividend growth model. A dividend that is projected to grow over time is worth more than a dividend that remains constant and will result in a higher current stock value. (the higher cash flow discounts to a higher current stock price)

for more advanced exams like the series 79, CFA or CFP

With regards to the dividend valuation model, expect to have to work out a growth rate. Sustainable growth rate is ROE x the retention rate. Also, when using Gordon’s Growth Model to work out an implied P/E, dividing both sides by EPS gets you (Div per share / Earnings per share) / (r – g) and that DPS / EPS = Payout ratio. The retention rate can be calculated as “1 – payout ratio”.

The Dividend valuation model is the most important formula within the equities section. You will need to be careful interpreting the question. You are looking for next year’s dividend. Where questions say, “last year’s dividend was” (or more confusingly even “this year’s dividend was”) you will need to gross up by a year’s worth of growth to work out what next year’s dividend will be.

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