by The General Dividend Valuation Model is a method used to value common stock, which assumes that the present value of a stock’s future dividends and its future sale price (also known as the terminal value) is equal to its current market price. This model is based on the principle that the value of an investment is based on the future cash flows it is expected to generate.
Assumptions of this model include:
- Dividends are the primary source of investment return: The general dividend valuation model assumes that investors purchase stocks primarily for the dividends they pay. The model is based on the idea that the value of a stock is equal to the present value of all future dividends that the company is expected to pay.
- Dividends are expected to grow at a constant rate: The model assumes that dividends are expected to grow at a constant rate, which is usually assumed to be the same as the long-term growth rate of the economy. This assumption is made to simplify the calculation of the present value of future dividends.
- Discount rate is constant: The discount rate used to calculate the present value of future dividends is assumed to be constant. This discount rate represents the investor’s required rate of return on the investment and takes into account factors such as the risk associated with the investment and the current interest rate environment.
- No significant changes in the company’s dividend policy: The model assumes that the company’s dividend policy will not change significantly in the future. This means that the company is expected to continue paying dividends at the same rate and growing them at the same constant rate.
The general dividend valuation model is commonly used by investors and analysts to determine the intrinsic value of a company’s stock. By using this model, investors can compare the intrinsic value of a stock with its current market price and make a decision on whether to buy, hold or sell the stock. The model is also used by companies to determine the appropriate dividend policy that will maximize shareholder value.
However, it is important to note that the general dividend valuation model has its limitations. It assumes that dividends will continue to be paid at a constant rate, which may not be the case in reality. The model also does not take into account other factors that can affect the value of a stock, such as changes in the company’s management or industry trends. Therefore, it is important to use this model in conjunction with other valuation methods and to consider a range of factors when making investment decisions.
The formula for the general dividend valuation model is as follows:
P = (D1 / r – g) + (P1 / (1 + r)^n)
Where:
P = the current market price of the stock
D1 = the expected dividend for the next period
r = the required rate of return
g = the expected growth rate of dividends
P1 = the expected sale price of the stock
n = the number of periods until the sale
The first part of the formula (D1 / r – g) represents the present value of all future dividends, while the second part of the formula (P1 / (1 + r)^n) represents the present value of the stock’s expected sale price.
The required rate of return (r) is the minimum rate of return that an investor requires to invest in the stock. It is based on the risk-free rate of return (such as the yield on a U.S. Treasury bond) plus a risk premium that compensates the investor for the additional risk associated with investing in the stock.
The expected growth rate of dividends (g) is the rate at which the company is expected to increase its dividends in the future. It is based on factors such as the company’s historical growth rate, its financial performance, and its future prospects.
The general dividend valuation model is useful for investors who are looking to invest in stocks for the long term and want to determine whether a stock is undervalued or overvalued. It is important to note that this model is based on several assumptions, including the assumption that dividends will continue to grow at a constant rate, which may not always be the case in reality. Therefore, it is important for investors to use this model in conjunction with other valuation models and to conduct thorough research on the company and its industry before making an investment decision.
