Does the Value of a Share of Stock Depend on Dividends?

For all the talk about "making money" in the stock market, a share of stock really produces money in only two ways: dividends and capital gains. A dividend occurs when the company's board of directors decides to distribute some (or all) of the company's profits to shareholders. Capital gains occur when you sell the share for more than you paid for it.

A bedrock principle of finance is the idea that the price of any investment is simply the present value of all the future cash flows that will be generated by that investment. "Present value" means, essentially, the value in today's dollars, after adjusting the future amounts for inflation and other factors. When people have differing opinions on the value of a share of stock, what they're really disagreeing about is the company's potential to produce cash flows for investors, either as dividends or capital gains. If your perception of a stock's present value is higher than the current share price, then it's a bargain, and you would buy the stock. But if the price exceeds your opinion of the stock's value, then you'd avoid it.

Several methods of valuing stocks focus solely on dividends, the most popular of these being the Gordon growth model. This model values a share of stock according to the formula D/(r-g), where "D" is the company's next dividend, "r" is the company's required return and "g" is the rate at which dividends are expected to grow in the future. The required return is the return investors expect the company to produce; it's the "price" of getting investors' capital, and it varies according to the return investors can get from other investments. Dividend growth rate depends on how much of its profit the company is expected to reinvest in itself, as opposed to distributing as dividends, and what kind of return the company is expected to generate on that reinvested capital.

Dividend-based valuation doesn't seem to take into account the potential for capital gains. But the theory behind dividend valuation is that a stock's price will rise or fall along with expectations for its dividends. Figure out the right values for "r" and "g," the thinking goes, and capital gains will be baked into the formula. One key criticism of dividend valuation is that it isn't of any use for companies that don't pay dividends; if "D" is 0, after all, then the stock's value should be zero, and that's simply not the case. Generally speaking, dividend-based valuation works best for mature, stable companies with a history of paying dividends. Young companies that are focusing their energies on growth rather than returning cash to investors are best evaluated with other methods, such as models that compare their earnings and other fundamentals with other companies in their industries.