Dividend and Non-Dividend Stock Valuation
Explain the merits and/or pitfalls of using the dividend growth model to estimate
the stock price of a non-dividend paying stock.
Then, compare and contrast how these variables affect the valuation of a
dividend paying stock and a non-dividend paying stock.
Introduction
Dividend Growth Model is one of the fundamental concepts for analyzing and determining the
average value of a company’s stock. It’s also referred to as Gordon Model. It’s utilized as a
strategy for estimating investments that are based on the actual gains that have been pegged on
the dividend yield. The growth model estimates the value of stock based on the current payment
of dividends and the general pattern of payment of dividends over the years by the company.
One of the companies that currently don’t pay dividends is Gilead Sciences (GLD) and is one of
the companies 500 SP companies.
Companies that have good dividend yields together with reasonable and better payout ratios are
mostly considered safe and reliable investments that also have good income and offer better
opportunities for capital growth. Generally, the dividend growth model indicates the past
performance of a company. To calculate the growth model, the current dividend payout and the
dividend growth rate together with the required or expected rate of return are utilized to arrive at
the growth model (Brav, Graham, Harvey & Michaely, 2004).
2 Dividend and Non-Dividend Stock Valuation
The conventional standards are that the DDM (Dividend Discount Model) cannot be utilized to
value a company’s stock that either pays very low dividends or no dividends at all. This concept
is wrong; the dividend payout ratio should be adjusted to accurately reflect the changes that are
expected from the growth rate. A fairly reasonable value for the firm can be thus obtained even
for firms that don’t pay dividends. A company that has a high growth rate and which is not
paying any dividends currently can still be rated and valued based on the expected dividend
payout when the growth rate reduces or declines. But if the company’s payout ratio is not
accurately adjusted or not adjusted at all to reflect the current changes in the rate of growth then
the DDM will underestimate the total value of the non-dividend paying company stocks or the
low-dividend company stocks paying (Bulan, Subramanian & Tanlu, 2007).
The DDM is mostly criticized on the grounds that it’s too conservative when estimating values.
This notion stems from the results that are based on the value that has been determined by
another value that’s more than actual present value of the expected dividends (Bosch, Montllor-
Serrats & Tarrazon, 2007). For example, its mostly argued that the DDM on average does not
represent the values of unutilized assets. There is no justification whatsoever that the unutilized
assets cannot practically be valued separately and later added to the DDM value. However, some
of the ignored assets by the DDM like brand names and their values can for all be accommodated
within the models context. The model does not incorporate ways of compensating stockholders
in cases of buybacks. The new version of the DDM has however countered this argument or
inadequacy.
Finally, the DDM model is considered contrarian. As the market for stock increases, less stock
will be undervalued using the DDM approach. This argument is not entirely true. If the stock
market improves or grows its largely because of the market’s fundamentals such economic
3 Ascension Strategy Essay – TED
growth in the country or may be due to reduced interest rates which means that the stock values
may also follow the same trend. However, if the growth trend is not due to the economic
fundamentals, then the DDM would also not follow the trend, in brief, the reactions of the values
of the DDM represent positions of strength and not weaknesses for the model. The model may be
signaling that stock market has been overvalued in relation to the cash flows and dividends hence
a cautious investor will follow the cue. The DDM provides very impressive results eventually in
the long term (Foerster & Sapp, 2005).
References
Brav, A., Graham, J.R., Harvey, C.R. and Michaely, R. (2004) Payout Policy in 21 st Century
Working Papers, Duke University, Durham, NC.
Bosch, M., Montllor-Serrats, J., & Tarrazon, M. (2007). NPV as a function of the IRR: The value
drivers of investment projects. Journal of Applied Finance, 17(2), 41–45. Retrieved from
Business
Bulan, L., Subramanian, N., & Tanlu, L. (2007). On the timing of dividend initiations. Financial
Management (Blackwell Publishing Limited), 36(4), 31–65. Retrieved from Business
Source Premier database.
Foerster, S., & Sapp, S. (2005). The dividend discount model in the long-run: A clinical study.
Journal of Applied Finance, 5(2), 55–75. Retrieved from Business Source Premier
Database.
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