The concept of valuing a share according to its dividend

Hypothetical Company A:

EPS  30 cents (1987)  36 cents (1988)
DPS 15 cents (1987)  18 cents (1988)
Annual increase in dividend  20%

Assuming the intrinsic value of the share = 25 times its dividend (i.e. the dividend yield of a share should be 4%),  what should be the correct price of a share of Company A in 1987 and 1988?

Correct market price:
1987:  25 x 15 cents = $ 3.75
1988:  25 X 18 cents = $ 4.50

The intrinsic value of Company's A shares increased from $3.75 to $4.50 in a year, thus giving a capital gain of 75 cents or 20% on the 1987 price. 

•  This is exactly the same as the increase in dividend. 
• So long as the dividend of Company A goes on rising, its intrinsic value would continue to rise, thus providing its shareholders with continuous opportunity for capital gain.

To recapitulate:

• This does not mean that the market price would indeed be at these levels. 
•  It merely means that the price would be oscillating around these prices in the respective years. 

Question:  "But why should the price go up just because the dividend of a share has increased?" 

• The reason is quite simple.  If the price does not go up while the dividend keeps on increasing, the dividend yield of the share will become higher and higher. 
• Since the shares of Company A are traded in the same market as many other shares, its shares cannot sell at a dividend yield that is much higher than its competitors.  If its dividend yield is very attractive (i.e. very high) it will attract more buyers and its price would go up. 
• Similarly, there is no reason at all why the price of a share should rise unless it has a prospect of paying more dividend in the future.  Otherwise, its dividend yield would get out of place compared with the other shares. 
• This is why all too often, the speculative shares which are bidded up to stratospheric levels will eventually decline to their previous level. 

Summary:

The concept of valuing a share according to its dividend is a very alien one to most of the investors. 

Most would find it difficult to accept and may even think that it is too simple a concept to be true. 

However, the dividend yield approach works well as an investment tool over the long term. 
 
It is beyond doubt that over the long run, the price of a share is dependent on the amount of dividend it pays out.  The higher the growth rate of the dividend, the higher the growth rate of the share.