Question

Explain the difference between using the zero-growth dividend valuation model and the constant-growth dividend valuation model when finding the intrinsic value of common stock and preferred stock ?

How does adding a growth rate to the valuation process affect the intrinsic value?

Answer 1

When finding the intrinsic value of stocks. using zero-growth or constant growth is an important decision. This decision is dependent on the historical performance of the stock and future expectations. Some stocks tend to provide all the income (most of the income) to the shareholders in the form of dividends, This leaves no room for reinvestment (unless arranged externally) for growth to happen, The zero-growth model is suitable in these cases,

The share price as per zero growth model P0 = D/r where D is the constant dividend paid every year and r is the required rate of return

However, in cases where dividend is less and the company reinvests a large part to provide for future growth , the constant or multistage growth model (as per the forecast of growth) are appropriate.

The share price as per constant growth model P0 = D1/(r-g) where D1 is the expected dividend next year, r is the required rate of return and g is the constant growth rate

Obviously , the constant growth model generally yields a larger Stock price

Thus adding a growth rate favours the stock valuation process and a higher estimate of stock price is obtained. The greater the growth rate assumed, the more the stock price