Why is a 5% dividend from Merck a good investment if you have a goal to double your money in five years?

Let’s say you have an investment that pays a steady, fixed amount each year forever!  It doesn’t matter what it is: a dividend, or some type of interest or an annuity. Let’s say that payment is $1.50 each year.  As mentioned above, people have different expectations of an acceptable rate of return.  To value this stream of payments, you divide the rate the investor requires into the annual payment.  So, with a payment of $1.50 and a return of 5%, the investment would be valued as follows:

The Dividend Discount Model starts to address some of the assumptions built into the discussion above.  First off, we know that for many good companies, the dividend grows over time.  (The discussion above assumed that the dividend never changed from year to year.)  If you have a rate of return that you require of your investments and you also know the average annual growth rate for the dividend, you can apply the Dividend Discount Model.  Let’s turn to Merck.  We expect an average return of 15% each year.  The dividend Merck pays has grown at about 6% a year—give or take!  (It used to grow more, but that growth rate appears to be slowing.)  To use the Dividend Discount Model, you subtract the growth rate in dividends (.06) from your expected return (0.15) and divide this difference into the current annual payment.  The result is illustrated next.

There might be another investor out there with a lower required return.  Let’s say that person is happy with his or her portfolio growing at 12% (0.12) each year.  This lower return implies a higher valuation on the company: $25.00 per share.