Question

Explain the difference between using the zero-growth dividend valuation model and the constant-growth dividend valuation model when finding the intrinsic value of common stock and preferred stock.

How does adding a growth rate to the valuation process affect the intrinsic value?

Answer 1

Zero growth dividend valuation model is a valuation model, which directly discounts the future value of all dividend, which are to be receivable at the present value and it advocates that the value of a company is a sum total of present value of its dividend.When there is no dividend growth then it will have to be discounted using the expected rate of return and it is directly to be divided by the expected rate of return to arrive at the value of the company.

P= (D1/ke)

In the constant growth rate dividend valuation model,the value of a company is derived by factoring into the growth rate of the dividend and getting substrateed it by expected rate of return, and then it is to be used to divide dividend payment in order to arrive at the market value of the company.

P=D1/ (Ke-g)

it can be derived from the above two models to calculate the dividend, as when there would be a discounting using a higher rate of return, as in zero growth dividend discount model, the value of the company would be comparatively lower.

When the dividend is to be divided by lower discounted rate, because expected rate of return has been substracted by the growth rate, the overall value of the company would be higher because it was discounted with the lower rate, so a growing company, which has the growth in its dividend will be having the higher valuation according to this philosophy.

so when there is a constant growth rate in case of dividend, the intrinsic value of the company would be comparatively higher because of dividend getting discounted by lower rate of discounting.