What is the primary assumption of the Dividend Growth Model?

The primary assumption of the Dividend Growth Model is that growth is achieved by reinvesting retained earnings. This model operates under the premise that a company's dividends will increase at a constant growth rate over time. The fundamental idea is that a firm can sustain its growth rate by retaining a portion of its earnings, which are reinvested back into the business to fund future growth, rather than distributing all profits as dividends.

By focusing on retained earnings, the model emphasizes the role of internal funding in driving growth. Companies that successfully reinvest their earnings contribute positively to their future cash flows, thereby increasing the total dividends that can be paid out to shareholders in the long run. This creates a sustainable growth environment where dividends increase predictably, reflecting the company’s ability to generate returns on reinvested capital.

In this context, understanding that growth is linked to retained earnings is crucial for investors and financial analysts using the Dividend Growth Model to predict future dividend streams and assess a company’s value.