Question

If stockholders receive payment in the form of dividends, how would we find what one share of ownership is worth to us today? Illustrate this by drawing a timeline and explaining the general valuation process.

Answer 1

The method to value a stock by future dividends is called Dividend Discount Model.

Dividend Discount Model prescribes that the present value of a stock is a summation of present value of all the dividends received from a stock.

So Lets take an example of a stock which is to give 10% dividend on its FV of $100 for next year and then grow forever at 10% then the value of Stock is P= D1/r-g

Here D1 = 10% of 100 = $10

r = Cost of Equity = 12%

g = 10%

P = 10/(0.12-0.10)

= 10/0.02

= $500

Lets understand if the the shares were to pay only 5 years and a constant dividend of $10 from next year and the cost of equity is 12% so lets understand it by timeline:

Dividend for Year 1 = $10 Now this dividend should be discounted at 12% for 1 years So 10/1.12 = 8.928 = 8.93

Dividend for Year 2 = $10 Now this dividend should be discounted at 12% for 2 years So 10/1.12^2 = 7.971 = 7.97

Dividend for Year 3 = $10 Now this dividend should be discounted at 12% for 3 years So 10/1.12^3 = 7.117 = 7.12

Dividend for Year 4 = $10 Now this dividend should be discounted at 12% for 4 years So 10/1.12^4 = 6.355 = 6.36

Dividend for Year 5 = $10 Now this dividend should be discounted at 12% for 5 years So 10/1.12^5 = 5.674 = 5.67

Now the Value of stock is the sum of the dividend the company is going to pay so 8.93+7.97+7.12+6.36+5.67=$36.05

So the value of stock is given by the sum of present value of all the dividends.