Question

5. According to the Gordon Growth model, stocks can be valued solely based on their dividend payments, the expected growth rate of those dividends, and the required rate of return.

a. How come we needn’t include the future sale price of the stock in the valuation?

b. Some stocks have not paid dividends for many years and have no announced plan to pay dividends in the near future. How can these stocks still have value?

Answer 1

a) We dont need the future price of stock in the valuation because,

Value of stock = D₁/ (k - g)

where D1 is the expected dividend, g is teh growth rate of dividend, k is the discount factor.

We use dividend discount model to determine the terminal value and its present value to find the current value of the stock. So it does not matter to consider the future sale value of the stock to calculate the PV of terminal value.

b) Some stocks do not pay dividends for many years and have no announced plan to pay dividends in the near future. But these stocks still have value because they may invest the money back into the business to grow at higher acceleartion rate. Even the top MNC's don't pay dividends and reinvest the earnings completely into the businesses to grow. These stocks will be undervalued when we value through the gordon growth model. So we have to take that into consideration in the valuation process.