Question
In: Accounting
you are a financial analyst who has been asked to value several dividend paying stocks. Name...
you are a financial analyst who has been asked to value several dividend paying stocks. Name two models you might use for this purpose. What are some shortcomings of these models?
Solutions
Expert Solution
Gordon Model:
Under this price of a share can be computed using the following formula:
P = D1/r-g wherein,
D1 = Dividend for Year 1 ie D(1+g)
r = Cost of Equity
g = growth rate
If the firm has no growth rate then g = 0.
The shortcomings of this model is that:
- This model assumes there is a fixed rate of growth which is not correct in the real world. It is really challenging to maintain a fixed rate of growth for bigger companies.
- If cost of equity is less than growth rate, the resulting price of the share becomes negative. Hence this model is not always useful.
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