Price appreciation vs. DDM

The standard dividend discount model (DDM) assumes that the stock is held forever and the value of the stock is the sum of all future dividends discounted to the present value. This causes some confusion with index investors who plan to fund their retirement by selling their basket of stocks. Some (wrongly!) assume that can somehow get a better return that from dividends only. Unfortunately, you cannot have the cake and eat it too: By selling the stocks, one gives up the right to the all the dividends after the date of sale. The price of the stock at the point of sale reflects the value of future dividends. In essence, the investor is giving up the right for the dividends for a lumped payment.

One way to look at this is that the total return on any given year is the dividend payment plus the stock price change. From year to year, the stock price changes can vary widely but the long term price growth will unquestionably match the long term dividend growth rate. Mathematically: 

Rate of return = dividend yield + dividend yield growth rate

                     = dividend yield + stock price appreciation 

The actual long term dividend growth rate has been 5.1% while the long term stock price appreciation stock price appreciation has been 6.5%. The difference is due to the stock market bubble that started to deflate in 2000. In the future, we can expect the stock price appreciation to be slower and in line with the dividend and earnings growth.