Dividend Models- Walter and Gordon Model

Dividend Models – Walter and Gordon Model

Introduction to Dividend Models

Have you ever pondered how a company identifies if it should pay dividends or invest the profits back into the company? Or how is the worth of those dividends figured out by investors? That’s exactly what dividend models are for. These tools reveal the connection between a business’ dividend policy and its overall value.

What Are Dividend Models- Walter and Gordon Model?

A dividend model is a calculation used to assess the worth of a company based on what it gives out to shareholders via dividends. Basically, they calculate the stock’s price by relating it to the income it provides to its shareholders.

Why Do Dividend Models Matter?

If you manage profits as an investor or as a company, learn about dividend models. They help settle financial issues by predicting the change in value if dividends are reduced or raised.

Understanding the Walter Model

Overview of Walter’s Model

Walter Model

Developed by John Burton Walter
Relevance: Considers dividends to be relevant to a stock’s price.
Key Assumption: The relationship between a firm’s investment policy (return on reinvestment, r) and its cost of capital (required rate of return, k) determines the optimal dividend payout ratio.
- If r > k (company earns more than its cost of capital): The company should retain earnings for reinvestment.
- If r < k (company earns less than its cost of capital): The company should distribute all earnings as dividends.
- If r = k (earnings equal cost of capital): Any payout ratio is acceptable.
Core Formula

$\frac{D + \frac{r}{k}(E – D)}{k}$
Where:

P = Price per share
D = Dividend per share
E = Earnings per share
r = Internal rate of return
k = Cost of capital

Variables in Walter’s Model

Earnings (E): Profit earned by the company.
Dividends (D): Portion of profits paid to shareholders.
r (Return): Return the company earns on its investments.
k (Cost): What investors expect as a return.

How Walter’s Model Works Let’s break this down into company types:

Growth Firms (r > k): If a company earns more on its investments than the shareholders expect, it should reinvest profits instead of paying dividends. That’s how value grows.

Normal Firms (r = k): Here, it doesn’t matter whether the firm pays dividends or reinvests. The value remains the same.

Declining Firms (r < k): Such companies should pay out profits as dividends because reinvesting won’t generate enough returns.

Strengths of Walter’s Model

Simple to understand.

Connects dividend policy with company value.

Helps categorize firms for dividend decisions.

Limitations:

Assumes perfect capital markets and no external financing.

Ignores factors like taxes and growth opportunities.

Difficult to implement in practice due to the challenge of accurately estimating r and k.

Gordon Model (Gordon Growth Model)

Developed by Myron Gordon
Relevance: Also considers dividends to be relevant to a stock’s price.
Key Assumption: The company’s dividends grow at a constant rate (g) forever.
Formula: Intrinsic Value per Share = D1 / (r – g)
- D1: Next expected dividend per share
- r: Required rate of return on the stock (discount rate)
- g: Constant growth rate of the dividends
Variables in Gordon’s Model
D1: Future dividends.
k: Required rate of return by investors.
g: Growth rate of dividends.

How Gordon’s Model Works

Impact of Growth Rate

If dividends are expected to grow steadily, the stock becomes more valuable.

Role of Discount Rate

A higher cost of capital reduces the present value of future dividends, lowering the stock price.

Strengths of Gordon’s Model

- - Intuitive and logical.
  - Widely used by investors.
  - Links growth and income perfectly.
Limitations:
- Assumes constant dividend growth rate, which may not be realistic in the long term.
- Ignores potential changes in the company’s risk profile.

In essence, the Walter Model provides a framework for thinking about how a company’s investment opportunities and cost of capital affect its dividend policy, while the Gordon Model offers a relatively simple formula to estimate a stock’s value based on the assumption of constant dividend growth.

Choosing the right model:

The Walter Model is more theoretical and may be helpful for understanding the conceptual relationship between dividends and a company’s value.
The Gordon Model is a more practical tool for valuation, but its accuracy depends on the validity of its assumptions, particularly the constancy of the dividend growth rate.

Comparing Walter and Gordon Models

Similarities

Both assume firms are financed internally.
Link dividend policy to firm value.
Assume constant return rates and no external funding.

Differences

Feature	Walter Model	Gordon Model
Focus	Reinvestment vs. dividend payout	Future dividend value
Assumptions	Return on investment vs. cost of capital	Constant dividend growth
Formula	P = D + (r/k)(E – D) / k	P = D1 / (k – g)

When to Use Each Model

Use Walter’s Model to evaluate dividend vs. reinvestment strategy.
Use Gordon’s Model for stable, dividend-paying companies with consistent growth.

Real-World Application of Dividend Models

For Investors

Dividend models help figure out if a stock is undervalued or overpriced based on dividends.

For Financial Analysts

These tools are used to advise clients, make valuation reports, and build investment portfolios.

For Companies

Understanding these models helps companies decide whether to pay dividends or reinvest.

Criticisms and Modern Perspective

Are These Models Still Relevant?

Partially. Today’s markets are more vibrant, and organizations can obtain funding in many ways. Still, the guidelines are helpful to consider.

Modern Modifications and Alternatives

Multi-stage dividend models.
Free cash flow models.
Residual income models.

These consider variables like changing growth rates and market volatility.

Conclusion

Walter and Gordon’s models provide us with insights into dividend policy. However, they play a key role in basic learning and deciding on financial policies to use in the long term. They might not be perfect, but they provide a great foundation for other solutions.

FAQs

What is the main difference between Walter and Gordon Model?

Walter focuses on reinvestment vs. payout decisions, while Gordon focuses on valuing future dividends.

Which model is more realistic in modern markets?

Neither model is perfect today, but Gordon’s is more commonly used due to its application in dividend-based valuations.

Can these models be used for startups?

Not really. Startups usually don’t pay dividends or have predictable growth, making these models ineffective.

What happens if a company doesn’t pay dividends?

These models won’t apply. You’d need alternative models like Free Cash Flow valuation or Residual Income approach.

Are these models useful for personal investing?

Yes, especially for evaluating mature, dividend-paying companies if you’re aiming for passive income.

It’s important to remember that both models are simplifications and should be used in conjunction with other financial analysis techniques to get a more complete picture of a company’s value.