Common Stock Valuation

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

dividends.

In general, a common stockholder also receives a return on her or his common stock in one of

two ways:

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

earnings

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

rate (g).

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)

where:

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).