According to the general valuation theory, the value of common stock is equal to the sum of all
the cash flows generated from the investment, discounted by the investors’ required rate of
return. Because the only cash flow generated from common stock until sold is the dividend
payment, the value of a common stock equals the present value of all the future preferred stock
In general, a common stockholder also receives a return on her or his common stock in one of
1. an increase in market value, which is caused by a higher stock price—normally because
of higher actual or expected generated earnings, or
2. by common stock dividends, which are expected to increase with higher corporate
To calculate the value of a common stock (Vcs), we must discount all future expected dividends
(D1, D2, D2, …Dn) to the present at the stockholders’ required rate of return, kcs. Now because the
amount of the annual dividends is not fixed and is typically expected to increase with higher
corporate earnings, we require a new assumption for the future dividend amount. One simplified
assumption, which would apply to many growing companies, is to assume that the dividend
amount is increasing by a constant growth rate each year. With this assumption, we can
determine the common stock value as follows:
Vcs = D1/(kcs – g) + D2/(kcs – g) + D3(kcs – g) + — + Dn/(kcs – g)
The above common stock cash stream can be shown algebraically to reduce to the following
equation when g, the annual growth rate is a constant:
Vcs = D1/(kcs – g)
Interpreting the above formula, we see the common stock value is equal to the next expected
dividend in year 1 (D1)(divided by the net of the required rate of return (kcs), minus the growth
This formula can also be written to use the last issued (previous, dividend) D, and the annual
growth rate g:
Vcs = D(1 + g)/(Kcs – g)
D1 = D(1 + g) = the next expected dividend
D0 = last or most recent dividend
g = annual growth rate
Vcc = value of common stock
Carefully note the relationship between the last issued (previous) dividend (Do) and the next
(expected) dividend D1 = D(1 + g).
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