Question

Under what two assumptions can we use the dividend growth model presented in the chapter to determine the value of a share of stock? Comment on the reasonableness of these assumptions.

Answer 1

Dividend growth model model for valuation of stock of a company. This method uses present value technique to evaluate the value of a share. The future value or expected dividend is discounted and bring to the present value under this method.

There are the following two assumptions for the use of dividend growth model.

(I). The dividend is expected to occur forever i.e in perpetuity.

(II). The growth of the dividend is at constant rate forever.

The reasonableness of both the assumptions is can be questioned under circumstances as explained here.

It is not possible for a company to give dividend each and every year. Sometimes a company has not in a profit to give the dividend or it may be possible the company is ceases to operate or dissolve itself then in such case it is not possible to distribute dividend.

Further with regard to second assumptions it might be possible that the company is a newly operated one who has and unstable in profit generation and thus the dividend could not be constant.

Thus it is not possible that both the assumptions will exist in each and every company for valuation of shares of such company by dividend growth model.