FNCE90060 Chap.6 Valuing Stocks and Growth
Valuing Stocks and Growth
Week 6 values equity from the cash flows shareholders expect to receive. A one-year investor receives the next dividend and the sale price, both discounted at the equity cost of capital. Extending the horizon leads to the dividend discount model: current price is the present value of expected future dividends. Expected total return decomposes into dividend yield and capital-gain rate.
Under constant growth, price equals the next dividend divided by required return minus growth, with the strict condition that required return exceeds growth. Timing matters because a dividend just paid is Div0 and must grow once to become Div1. Payout and growth are linked through retention. Retaining earnings creates value only when new investment earns more than the opportunity cost; growth in earnings alone is not enough.
What this chapter covers
- 01
One-year stock valuation
- 02
Dividend yield and capital gains
- 03
Multi-year dividend discount model
- 04
Constant dividend growth
- 05
Payout and retention
- 06
Profitable growth and market efficiency
Worked example · free
Apply constant dividend growth
- 1Convert the dividend just paid into the next dividend: $1.50 times 1.04 equals $1.56.
- 1Check that required return 10% exceeds growth 4%.
- 1Price equals $1.56 divided by 0.10 minus 0.04.
- 1Current value equals $26.00 per share.
Key terms
- Equity Cost
- The expected return required by investors for bearing the share’s risk.
- Dividend Discount Model
- A model valuing equity as the present value of expected future dividends.
- Capital Gain Rate
- The expected change in share price divided by the current price.
- Payout Ratio
- The fraction of earnings distributed to shareholders as dividends.
- Retention Rate
- The fraction of earnings retained for investment rather than distributed.
- Profitable Growth
- Growth created by new investment whose return exceeds its opportunity cost.
Valuing Stocks and Growth FAQ
Why is the future sale price part of a one-year valuation?
The investor expects to receive both the dividend and proceeds from selling the share. Both amounts occur at year end and must be discounted at the equity cost of capital.
Why must required return exceed perpetual growth?
The constant-growth model needs a positive denominator and a stable long-run relationship. Growth at or above the required return forever is not a sustainable steady-state assumption for a finite current value.
Does a dividend cut always reduce share value?
No. Retaining cash can raise value when it finances positive-NPV investments whose return exceeds the equity opportunity cost. Retention destroys value when projects earn too little.
How do I avoid using the wrong dividend?
Label the stated amount Div0 if it was just paid and Div1 if it is expected next period. Grow Div0 once; use a stated Div1 directly without another growth adjustment.
How does expected total return split into two parts?
Dividend yield is the next expected dividend divided by today's price. The capital-gain rate is the expected price change divided by today's price. Adding them recovers the equity cost of capital in the one-period valuation identity. Keep all three quantities on the same horizon before comparing them.
When is a constant-growth model inappropriate?
It is inappropriate when the firm is in a temporary high-growth stage, payout and reinvestment are unstable, required return does not exceed long-run growth or dividends do not represent the expected shareholder cash-flow pattern. Use a multi-stage forecast until operations reach a defensible steady state, then apply a terminal growth model.
What determines whether retention creates value?
Compare the expected return on new investment with the equity opportunity cost for comparable risk. Retention adds value when the firm can invest at positive NPV and turn forgone current dividends into a more valuable future stream. Growth in accounting earnings alone is insufficient when reinvestment earns below the required return.
How can the one-year model check a Gordon valuation?
Under stable growth, grow the current price and dividend one period, add the next dividend to the expected sale price and discount both at the equity cost of capital. The result should reproduce today's Gordon price. Failure to reconcile usually signals a Div0 versus Div1 timing error or inconsistent growth assumption.
Exam move
Start with the investor timeline: next dividend plus future sale price. Practise decomposing total return into dividend yield and capital gain. For constant growth, write Div0 or Div1 beside the amount, verify required return exceeds growth and check that dividend yield plus growth returns the equity cost.
For payout questions, trace retained earnings into new investment and compare its return with shareholders’ opportunity cost. Avoid slogans about dividends or growth; conclude from the present value of the resulting cash flows. Reconcile each Gordon result with the one-year pricing identity and test how value moves when return or growth changes.
For retention cases, state the forgone current dividend before judging the NPV of the investment it finances.
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