Question

In 500 words or more, discuss how stock prices depend on future dividends and dividend growth. Also, discuss the difference between common and preferred stocks.

Answer 1

The stock prices depend on future dividends and dividends growth rate. The dividend history of a stock plays an important role in it's popularity among the investors. As, dividends serve as an important source of income, the declaration of dividend has a major effect on the stock price. So, as the dividends paid by the company increases, and the rate at which the dividend grows increases , investors will be more willing to purchase the stock which will drive up the stock prices. Dividends are paid from the company's retained earnings, so it also an indicator that the company who are profitable will only declare dividends consistently. The company declaring dividends consistently are very valuable for the buy and hold investors , they take advantage of the stock ownership and this naturally drives up the stock prices.

According to the Gordon growth mode, the value of the shares is dependence on the dividends paid and the rate of growth of dividends. The dividend discount model uses dividends (or income) to generate an intrinsic value. The formula takes the future expected dividend stream of a company and discounts it back to its present value.

The constant growth dividend discount model assumes that a company is growing at a constant rate. It is best used for large, stable companies that have consistent earnings and dividends. However, small- and medium-sized firms that are growing their earnings and dividends steadily can be valued using this approach as well. The formula for the constant growth model is:

Po = D0* (1+g) /(Re - g )

So, the stock prices depend on future dividends and dividend growth. Similarly, when the company lowers the dividend paid, this will lead to the lowering of the stock prices as the investors view this unfavourably.

Preferred stocks pays dividends at regular intervals similar to bonds. Common share holders pay dividend only if the firm is generating adequate profits. The preferred stock holders are given priority over the common share holders in the event of the liquidation of the company. the common share holders have voting rights which the preferred share holders do not have nay voice in the future of the company. Like bonds preferred stocks value is dependent on the interest rates, as the interest rates falls the value of the stocks rises and vice versa. The market for preferred shares often anticipate call backs and prices may be bid up accordingly.

Common stock and preferred stock both represent ownership in a company. Both the categories of shares want to profit from the operations of the company. Common share holders have the biggest potential for long term gains . If the financial performance of the company is good, the investors reward in the form of higher stock prices , on the other hand if the company performs poorly, the stocks can also crash.

Preferred shares can be converted to a fixed number of common shares, but common shares don't have this benefit. In the times of liquidation when the assets of the company is distributed, the common share holders are the last in line. The bond holders are paid first, then the preferred share holders and lastly the common share holders.