Financial Education

The dividend discount model values a stock on the basis of dividends paid, growth in dividends and a required return. If the company is not expected to grow, the rational response would be to pay out all earnings as dividends. In such circumstances, the value should reflect the current earnings divided by the required return, or E/r. This is the no-growth value per share.

Since we know what the value of a stock should be if it does not grow, we can also infer how much value the market is assigning to future growth opportunities. The total value must is V = E/r + PVGO where E/r is the no-growth value and PVGO is the present value of growth opportunities.

Consider, for example, a stock earning $1.00 per share with an 8% required return. If the stock is currently trading at $20.00 per share, we can compute a no-growth value of $12.50 and a PVGO of $7.50.

For more information, see all articles on: Investing in Stocks, Valuation

See also:

A Three Stage H-Model Dividend Discount Model

The Sustainable Growth Rate

Valuing a Non-Dividend Paying Stock Using the Dividend Discount Model

The H-Model Dividend Discount Model

The Growth Duration Model