FNCE90065 Chap.8 Share Valuation and Growth
Share Valuation and Growth
Share value reflects expected shareholder cash flows and required return. This chapter values a constant-growth dividend stream, then extends the method to changing growth by forecasting explicit dividends and a terminal value.
It distinguishes the dividend just paid from the next dividend, locates terminal value at the forecast horizon and shows why valuation is sensitive to the spread between required return and long-run growth. Every answer states the assumptions that make the estimate possible.
What this chapter covers
- 01
Dividend valuation discounts expected shareholder cash flows
- 02
The next dividend belongs in the constant-growth numerator
- 03
Required return must exceed perpetual growth for the model to converge
- 04
Changing growth separates explicit forecast dividends from terminal value
- 05
Terminal value is measured one period before the first cash flow it capitalises
- 06
Sensitivity analysis tests required return and growth assumptions
Worked example · free
Value a stable dividend stream
- 1Grow the dividend just paid to next year's dividend of $1.854.
- 1Confirm required return exceeds perpetual growth.
- 1Divide $1.854 by the 6 percentage-point spread.
- 1Estimated current value is $30.90 per share.
Key terms
- Dividend discount model
- A dividend discount model values a share from the present value of expected dividends.
- Next dividend
- Next dividend is the first cash distribution expected after the valuation date.
- Constant growth
- Constant growth assumes dividends increase at one sustainable rate indefinitely.
- Terminal value
- Terminal value summarises cash flows beyond an explicit forecast at the horizon date.
- Required equity return
- Required equity return is the compensation shareholders demand for timing and equity risk.
Share Valuation and Growth FAQ
Why do I use the next dividend in constant growth?
Current price is measured immediately before the future dividend stream begins, so the numerator must be the first dividend expected after valuation. If the most recent dividend has just been paid, grow it once to obtain the next dividend before dividing by required return minus growth.
Where does terminal value sit on a timeline?
Terminal value sits at the end of the explicit forecast, one period before the first dividend it capitalises. Discount the explicit dividends and terminal value back to time zero. Do not also add later dividends separately because they are already inside terminal value.
Why is share value sensitive to growth assumptions?
In a constant-growth model, required return minus growth is the denominator. Small changes in either input can materially change that spread and therefore value. Long-run growth also affects every distant dividend, so a responsible estimate reports sensitivity instead of presenting one output as precise truth.
Exam move
Draw a dividend timeline and label the most recent dividend, next dividend, explicit forecast horizon and terminal value. Practise translating wording such as just paid, expected next year and growth begins after year three into dates before selecting a formula. Recalculate one example under a higher required return and higher growth to learn directional sensitivity.
For changing growth, verify that terminal value begins with the first stable-growth dividend and that no later dividend is double counted. Finish with one sentence naming the growth and return assumptions behind the estimate. Build three versions of the same valuation: zero growth, stable growth and two-stage growth. Keep the required return constant at first so the effect of the growth assumption is visible.
For the stable-growth model, write the next dividend in the numerator and check that required return exceeds growth; if that condition fails, stop and explain why the perpetuity expression is not economically usable. In a two-stage problem, list each explicit dividend separately, calculate the first stable-growth dividend, place terminal value one period before that dividend and discount every item to time zero.
Highlight the boundary date because most double-counting errors occur there. Reverse the model once to infer the growth rate or required return embedded in an observed price, then describe how sensitive that inference is to small input changes.
Compare dividend valuation with a broader cash-flow perspective for a firm that retains most earnings, noting that a mechanical dividend model can be uninformative when payout policy does not represent capacity to distribute cash. Practise explaining whether a price response comes from revised cash-flow expectations or a revised discount rate.
End with a scenario table showing a higher next dividend, higher long-run growth and higher required return. Predict the direction of value for each isolated change before calculating. Your final answer should state the valuation date, dividend convention, terminal-value date and at least one limitation of the assumed growth path.
Add a payout-policy scenario in which current dividends fall because profitable reinvestment rises. Explain why a lower immediate dividend need not reduce value when the retained funds credibly generate future distributable cash.
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