Dividend and Non-Dividend Stock Valuation
Investors who invest in stocks often like to receive returns on their investment in the form of dividends. However, not all companies opt to offer dividends to their investors. There are three variables that affect the valuation of a dividend and non-dividend paying stocks and how stock valuation is influenced. Those variable influences include size, timing, and uncertainty of cash flows that the asset will generate for investors over its lifetime.
Company that does not pay dividends.
A company offering dividends is a potential signal to investors that the company is settling down and that its growth days are over. Dividends often depend on the size of earnings, and are key in determining the value of equity. Google Inc. is a company that actively invests in future company growth initiatives. Google does not offer dividends as the company hopes to continue its expansion into new business ventures. Taking into consideration the size of Google as a company, it is highly likely that the company will provide dividends at some point in the future. The dividend growth model can be calculated as the stock value equals next year’s dividends divided by the required rate of return difference and the constant growth assumption in dividends. A dividend growth model evaluates and considers dividends within share value and growth.
Merits and/or pitfalls of using the dividend growth model
Organizations that are likely to pay dividends in the future can benefit from using the dividend model. Investors can gain a return on their investment by purchasing stock from non-dividend paying companies and then resell those stocks for a profit. The problem with this method is that the stock is only worth what the next investor is willing to pay. If a company does not pay dividends and instead reinvest the profits into other investments, it could raise the value of the shares to be sold. The concern with using the dividend growth model is that it does not include risks. Furthermore, the model is only effective for company’s that pay dividends and is growing at a constant rate.
How variables affect the valuation of a dividend paying stock and a non-dividend paying stock.
Dividend paying stocks usually perform better than non-dividend paying stocks, considering the immediate value. Non-dividend paying stocks such as Google could use the model to predict future growth rate if Google were to ever start paying dividends. Cash dividends are generally easier to measure. Considering Google is a well-known stable company, if it were to ever begin paying stocks, the model could assume that the dividends would be constant for a time. As an investor, dividend-paying stocks are often a better investment as it can predict a return on investment. In determining equity value, both dividend and earnings-based models can be used.
The Gordon Growth Model is a good way of calculating a stock value. However, it can only used with company’s that pay a regular dividend at a constant rate. Consequently, the model is only effective for stable companies. In addition, it will only work if it the assumptions are continually proven accurate. The model also values the company based on investor payment and assumptions and does not consider anything other than the dividend when valuing the company. Investors and analyst like the model because It is an easy and simple to use method for generating assumptions. For lower dividend paying companies with high dividend growth, the Gordon growth model may not be appropriate. Regarding the dividend growth model, its shortcoming is that the model assumes the growth will be constant. However, there is no guarantee that the growth will be constant as it can be cut. A solution to this shortcoming is to move toward a two-stage or multi-stage dividend discount model (DDM). A multi-stage DDM estimates that a dividend will grow over a number of years at a certain rate.
A dividend discount model (DDM) is a way of applying net value analysis to estimate the future stock dividends and how much it will payout. The dividends calculated are then discounted back to their current value. DDMs assess the stock value based on growth rate. The projected growth rate is compared to the associated discount rate, and the current value is then determined. If the current value is more than the future market value, then that stock is undervalued, which is good for purchasing. The model is an effective tool used by many investors and analyst looking to select stocks. A disadvantage of the model is that it is not suitable for company’s that do not pay dividends. While DDM does not explicitly consider risk, it does assist in estimating the market risk premium. The DDM requires long-term growth rate data in dividends. The advantage of DDM is its simplicity of use.