Question

Two of the dividend valuation models used in equity valuation are the zero growth model and the constant growth model. If you were trying to decide which model is best suited to use in valuing a particular company's common stock, what deciding factors would you take into account when trying to choose between the zero growth model and the constant growth model? When comparing the use of these two models, how would each impact the price you would be willing to pay today for that particular common stock issue?

Answer 1

Ans: Constant growth model is best suited to use in valuing a particular's common stock as compared to zero growth model.

Price on today is sum of all the future benefits received from share as on today. so if future benefit dividend is more due to growth, its present value today is more than the zero growth model in which benefit would remain same always.

As Growth = Retention ratio * Reurn of company.

As growth is dependent on return of company, if return increases , so called growth and so will price of the company.

price of share = P0 ( price tpday) = D1/ Ke - G

Factors to decide are 1) future benefits.

2) interest rate, inflation rate in the industry.

3) Return of the company

While comparing the two methods above, it is analysed that, the impact on price would be:

In constant growth model, the price of the stock would be high today as compared to the zero growth model as formula indicates:

P0 ( price tpday) = D1/ Ke - G, Under zero growth model, D1 will remain same every year alwaya and so growth rate also.

while under constant growth model, D1 will be increased every year and so called growth rate also increases.

So price on today will increase in constant growth model.as price on today is sum of all the future benefits received from share as on today. so if future benefit dividend is more due to growth, its present value today is more than the zero growth model in which benefit would remain same always.