Question

Which of the following statements best describes the concept used to value shares? Select one:

a. Market price can be expressed as the present value of an infinite stream of dividends assuming a company has an infinite life.

b. The present value of the dividend stream and expected capital gain must be calculated separately and then added together.

c. The value of an infinite stream of dividends discounted by the current short-term interest rate assuming a company has an infinite life.

d. Market price can be expressed as the present value of an infinite stream of dividends.

Answer 1

Solution:-

There are various concepts that are used to value shares, with all concepts using different metrics for valuation such as dividends, earnings, free cash flows.

While the present value of earnings and cash flows are considered as the best methods for valuation of shares, the four options given in the question include only statements related to dividends with the exception of point b.

As discussed, while there are concepts that are followed and which are based on valuing shares through present value of earnings or cash flows, however there is no concept that values shares by adding dividends and expected capital gains. Therefore, option b is not the correct option.

In terms of the remaining 3 options related to dividends, we should look to the dividend discount model which calculates value of share as present value of an infinite stream of dividends assuming that the company is a going concern having an infinite life and for this puprose uses the company's cost of equity as discount rate rather than short-term interest rates.

Therefore, options c and d are not correct as they don't meet the conditions of dividend discount model.

Therefore, the correct option is option a.