Question

The constant-growth dividend discount model is probablyone of themost popular formula for stock valuation. In your own words, describe the modelandits use.In addition, discuss the implicationsfor shareholder value maximizationbased on theformula(i.e. what a company should do), as well as, the difficulties in achievingthat.

Answer 1

The constant-growth dividend discount model is also known as Gordon Dividend Model which assumes that company pays regular dividend at constant growth rate for forever therefore intrinsic value of share can be determined by discounting all the future cash flows (dividends) to the present value. Cost of equity (re) is required rate of return and it is used as a discount rate for present value calculation.

Formula to calculate the current share price by dividend discount model with constant growth rate

Stock Price P = D1 / (re – g)

Where required variable are -

The cost of equity (re)

P = the current stock price

D1 = dividend for next year

g = constant growth rate of dividend

Shareholder value maximization based on the formula is possible by keeping required rate of return as low as possible because it used as a discount rate and growth rate of dividend as high as possible but growth rate should not be more than the required rate of return otherwise this formula will not work.