Common Stock Valuation

Explanation

To determine the value of a common stock using the Infinite Period Dividend Discount Model, use the following equation:

{V = [d1 / (k - g)]}

Where: V = the value of the common stock at t0, d1 = the annual dividend at t1 (which is found by multiplying d0 by (1 + g), k = the investor's required rate of return, and g = the anticipated annual growth rate.

In this example, all of the necessary information has been provided, and incorporating this information into the Infinite Period DDM will lead to the following:

{V = [$2.80 / (0.1525 - 0.1275] = $112}

This value is very close to the value of the common stock in the open market.

An important observation: notice that we have valued this common stock as a perpetuity, rather than a finite series of cash flows. The reasoning behind this approach should be somewhat intuitive. Specifically, unlike a bond, whose cash flows possess a finite lifespan, the cash flows (i.e. dividends) produced by a common stock could theoretically last forever. Is this a realistic assumption for most common stocks? What about a stock that pays little or no dividend?