When an investor pays for buying common stock, he expects to receive future cash flows in the form of dividends. When the stock is sold, the investor expects to receive the value of the stock.
It is difficult to determine the value of the common stock because the future cash flows generated by dividends are not fixed. To determine the overall value of a stock dividend valuation models are used.
The benefit of dividend valuation models is dividends are used to value the company and this is not total value because debt is not included. Different dividend valuation models are described below:
The Basic Valuation Model
The basic valuation is that in a rational market stock value is the present value of all future cash flows that the investor expects to receive.
The time value of money principle can determine the present value of a stock based on the discounted value of future cash flows.
Shareholders pay for the current share price and acquire the shares with the expectation of future dividends. The formula for the dividend valuation model is:
P0 = D(1+g)/(re-g)
P0 = The current ex dividend share price
D0 = The dividend that has just been paid or will be paid
re = The required rate of return
g = The dividend growth rate
The required rate of return indicates the time value of money for the uncertainty of the future cash flows of the investment.
Where there is greater uncertainty, the greater required rate of return is required. When dividends grow at a constant rate the value of stock is the present value of a growing cash flow.
The Gordon Growth Model
The Gordon Growth Model assesses the reason of dividend growth. If all earnings of a company are distributed as dividend the company will not have additional capital to invest. The Gordon Growth model formula is given below:
G = bR
b = The proportion of earnings retained
R = The rate that profits are earned on new investments
Modigliani and Miller’s dividend irrelevancy theory
According to this theory dividend patterns have no effect on the share price. If a dividend is reduced now the extra retained earnings will allow future earnings and dividends to grow.
The equilibrium will reach when the retained amounts will be reinvested at the cost of equity. If a company retains earnings and uses it for reinvestment the share prices may not be affected.
The company can use the retained earnings to produce higher returns and then dividends should be reduced to increase shareholder value.
But when the company will use the retained earnings to produce lower returns then dividends will need to be increased to avoid the falling of share price.
Zero Growth Dividend Valuation Model
This model is used when a company’s dividend payments are expected to remain constant. The formula is:
P0 = D/ke
The model can be used to estimate the value of a stock for which dividend payments are expected to remain constant for a long period in the future.
Constant Growth Dividend Valuation Model
This model is used when a company’s dividend payments are expected to grow at a constant rate for a long period. The formula is:
Dt = D0(1+g) ^t
The model assumes that a company’s earnings, stock price, and dividends are expected to grow at a constant rate.
There are many theoretical models for dividend valuation, but the practical considerations also matter. The announcement of dividend is publicly available information and in a semi-strong form of the efficient market, the share price will react to this information.
There is information asymmetry that is not in the public domain and shareholders will be unsettled by abrupt changes in dividend policy.
If investors do not share the director’s optimism about the company’s future success, the share price will be affected.
Another thing is that tax can affect investment decisions. When a company suddenly changes its dividend policy, it will disturb investor’s portfolios and investors have to adjust their mixed portfolios.
Company liquidity is an issue as companies have to ensure that their position is sound, and they may have dividend reductions if they have to stay solvent. Sometimes dividends are reduced by lenders who put clauses in the loan agreement.
Because if less cash is paid liquidity may be better. Sometimes, there may be some legal constraints for paying dividends.
It can be stated at the end that the dividend model is useful when valuing a company that pays dividends. The basic principle behind the valuation model is that the value of a stock today is the present value of future dividends.