Corporate / Stock Valuation Methods

Question 1

What is the Dividend discount model?

Answer 1

The dividend discount model (also known as the dividend growth model) is a method of arriving at the value of a stock by using expected dividends per share and discounting them back to present value:

= Dividend per share / (Cost of capital - Dividend growth rate)

This method is used when dividends are expected to grow at a constant rate. If the value obtained using this formula is greater than the stock’s current fair market value, then the stock is considered to be undervalued (meaning it is worth more than its fair market value)

Question 2

How is preferred stock valuation?

Answer 2

Preferred stock usually pays a fixed dividend. When this is the case, the value of the stock can be calculated as follows:

= Dividend per share / Cost of capital

This formula can also be used when dividends on common stock are not expected to grow

Question 3

What is the Two-stage dividend discount model?

Answer 3

Dividends do not always grow at a constant rate. When this occurs, stock valuation become difficult. Many companies experience a two-stage growth. In the initial phase, growth can be very rapid and unstable. In the second phase, growth slows down and stabilizes

In the second phase, growth slows down and stabilizes. In these situations, the two-stage dividend discount model can be used effectively calculate the stock value

This calculation requires 3 steps:

1. Calculate and sum the present value of dividends in the period of high growth
2. Calculate the present value of the stock based on the period of steady growth, discounting the value back to Year 1
3. Sum the total calculated in Step 1 and Step 2