Stock Valuation

The shareholders buy shares with the expectations of receiving dividends and increase in the value of the shares. A conscious investor buys shares when they are undervalued and sell them when they are overvalued. Under valuation means the shares’ true value is more than their market value and overvaluation means their true value is less than the market value. The true value of a share is the present value of all future dividends over an indefinite time period. As the future dividends keep on growing therefore it’s become imperative to compute the value of the share with respect to expected growth pattern of future dividends. According to growth theory the valuation models can be categorized into three broad categories.

• Zero Growth Model
• Constant Growth Model
• Variable Growth Model

Zero Growth Model

If a firm pays constant dividend every year the value of the share is calculated under the zero growth model. This model assumes no growth in dividend and value of share would equal the present value of perpetuity of dividends discounted at the required rate of return. Symbolically,

P = D1 / Ke

Where,

P   = Price of the share
D1 = Constant dividend per share
Ke = required rate of return for investors

Example

A firm pays dividend of $10 constantly over an indefinite time horizons. Required rate of return for investors is 16%. Compute the value of the share.

Solution

P = $10 / 0.16 = $62.5

Constant Growth Model

When dividends grow at a constant rate every year the value of the share is determined through constant growth model. This model also called Gordon Model. The value of the share is given by the following equation.

P = D1 / Ke – G

Where,

P    = Price/value of the share
Ke  = Required return
G    = Growth rate in dividend

Example

A firm paid the dividends over the six years at constant growth rate of 7%. Required rate of return is 16% and in year 7 DPS expected is $3. Compute the value of the share.

Solution

P = $3 / 0.16 – 0.07 = $33.3%

Variable Growth Model

Most of the firms pay dividends over the years with some growth rate and after that the growth rate is changed. In this case computations of value of the share become more complex because it incorporates the changes in the dividend payment over the years. In this model the share value is determined through following steps:

1. Compute the present values of the expected cash dividends for the initial growth years and compute the sum total.

2. Find out the value of the share at the end of year from which dividend growth is expected to change.

3. Determine the present value of the value of the share computed in step 2.