How to Value a Dividend Growth Stock

While there are many ways to value a company, there are 3 main ones that I use when I am looking to value a dividend growth stock.

No one valuation method is perfect so it is best to use a few and come up with a price that makes sense to you.

I will be detailing the following methods:
Discounted Cash Flow (DCF)
Dividend Yield Theory
P/E Mean Reversion

How to Value a Dividend Growth Stock

For all three methods, I am going to be using Pfizer, stock ticker PFE, the drug manufacturer.

Discount Cash Flow (DCF)

Calculates the current value of a stock based on what earnings you expect in the future

Formula: EPS x (1+earnings growth rate)^number of years in the future) x average P/E ratio of the stock / (1+your required rate of return)^number of years in the future)

So that looks pretty complex but it is not too bad 🙂

So for Pfizer, here are the inputs you need:
EPS: Earnings per share for the last 12 months
Earnings Growth Rate: what you expect the earnings to grow in the future, you can find this at old.nasdaq.com
Number of years: I would do 5 or 10 years
Average P/E: what the company’s historical P/E ratio is. You can find this on yahoo finance, gurufocus, and other financial websites
Required Rate of Return: this one is up to you. How much do you want to make on the capital appreciation of your investment. I use 8% as this is the average stock return over the past 90 years, but it is up to you.

EPS: $2.87
Earnings Growth Rate: 4.47%
Number of years: 5
Average P/E: 17.69
Required Rate of Return: 8%

Using these figures, here is the formula again:
($2.87 x ((1.0447)^5) x 17.69) / (1.08)^5 = $42.83

Based on these inputs, the fair value of Pfizer is $42.83, Pfizer is currently selling at $38.05, so it appears that Pfizer is selling at a slight discount to fair value. The lower it is compared to fair value the more of a margin of safety you have in case your projections don’t work out.

Dividend Yield Theory

This calculation is based on the fact that a well established stable company will revert to the historical average dividend yield payout over time. It might take time for it to revert but generally it will, either by the price going up or down or the dividend payments increasing.

This one is easy.
Current Dividend Payment (last 12 months) / Historical Dividend Yield

For Pfizer, here are the inputs you need

Current Dividend Payment: you can find this on any financial website
Historical Dividend Yield: most financial websites will show this, Yahoo Finance, Gurufocus, Seeking Alpha

Current Dividend Payment: $1.52
Historical Dividend Yield: 3.47%

Using these figures, here is the formula again:
$1.52 / 3.47% = $43.80. Which shows the current fair value of the company

P/E Mean Reversion

Like the dividend yield theory, a quality stable company should revert to its average P/E over time.

This one is easy too:
Current Earnings Per Share (last 12 months) x Historical P/E

Current Earnings Per Share: can be found on any financial website
Historical P/E: can be found on most financial websites will show this, Yahoo Finance, Gurufocus, Seeking Alpha

Current EPS: $2.87
Historical P/E: 17.69

Using these figures, here is the formula again:
$2.87 x 17.69 = $50.57

So looking at all three figures

DCF: $42.83
Dividend Yield: $43.80
P/E Mean Reversion: $50.57

Since no one method is perfect, I would assume that a fair price is somewhere around $44-$45 for Pfizer.

If you can get the stock at a lower price, then you are buying at a good value, as long as the fundamentals of the company are still intact.

Hope that helps on how to value a dividend growth stock!

**Full disclosure, I own shares of PFE. In addition to valuation, make sure you are aware of the risks of the company and industries you invest in. Make sure you understand the business and their future prospects. Also, make sure you have a well diversified portfolio. As they say, don’t put all your eggs in one basket.