Difference Between Capital Asset Pricing & the Dividend Growth Model by Kevin Johnston

Difference Between Capital Asset Pricing & the Dividend Growth Model

by Kevin Johnston

When your small business generates excess cash, you should put that cash to work. If you look at the stock market as a place to put your cash, you need to analyze the potential for creating income or value from that investment. Two prominent models for evaluating a potential investment are capital asset pricing and dividend growth. Each has advantages and disadvantages that you should learn.

Price Appreciation

You can use capital asset pricing as a way of calculating whether your investment can grow. This model takes into account the risk of the marketplace in general and the risk of the company who issued the stock. You can protect yourself from the risk that one the company’s fortunes may decline by diversifying. In other words, invest in a variety of companies in case one of them fails. This can give your overall portfolio protection against business failure. You cannot protect yourself from a decline in the market. If the stock market experiences falling prices, your stock will most likely follow the decline. Therefore, your considerations for investing under the capital asset pricing model focus on the potential for a rise in the stock price.

Dividend Appreciation

You can invest your cash by finding stocks that show consistent growth in the amount they pay in dividends. Look at five years of history on the stock to see if the company has consistently raised its dividend. You will find many online stock-charting services that show when a company increases dividends. Your income from this investment will consist of dividend payments to you plus some price appreciation. This model assumes a company is financially healthy if it can raise dividends it pays to stockholders.

How Dividends Affect Price

A stock that pays a dividend can attract investors. As the demand for that stock grows, its price goes up. When the price rises to the point that the dividend is no longer a high percentage of the price of the stock, the price goes back down. This see-saw effect may keep the stock from rising in price significantly, unless the company raises the dividend. Even if the dividend goes up, the stock price may rise with it and then reach equilibrium again. In short, your investment in dividend stocks should focus on the income you will receive from the dividends, with only slight price appreciation in the stock.

Comparative Risks

With capital asset pricing, you run the risk that the market may become sluggish or weak and drag your stock down with it. Even if you have diversified, all of your stocks can be dragged down by a weak market. With dividend-growth stocks, you run the risk that the company may not make enough money and will have to cut its dividends. This will not only reduce your dividends, it will drive the price of the stock down.

Short-term Parking

Stocks do not make good choices for quick places to store your cash. Under the capital asset pricing model, you must hold stocks for long enough to allow the price to increase enough to justify the investment. This usually takes years. With dividend stocks, you receive dividends quarterly, and you must own the stock throughout the quarter in order to be paid. You will need several quarters in order to realize significant income from your investment.