Stock valuation: Two-stage Dividend Growth Model (Critical Review)

By Jackie, Researcher

Topic: Education

Area of discussion: Finance

Chapter: Valuation of Assets and Company (Stock valuation model)

The objective of this week’s research is to compare which method is more accurate, faster and consumes lesser time by comparing the table method and the formula method to calculate the two-stage dividend growth model. Step by step tutorial is provided below with clear explanation and workings.

Introduction

Ideally, many companies will usually experience above normal growth rates for a short period of time before settling in on a lower but stable perpetual growth rate. Thus, it would be inappropriate to calculate the stock’s intrinsic value based on the single-stage dividend growth model. Unlike single-stage dividend growth model, the two-stage dividend growth model formula is often not provided in exam.

Sample question

Compute the value of a share of common stock of a company whose most recent dividend was $2.50 and is expected to grow at 3 percent per year for the next 5 years, after which the dividend growth rate will increase to 6 percent per year indefinitely. Assume 10 percent required rate of return.

Therefore, by using the formula method, we can actually save a lot of time (especially during examinations as the time is limited). Besides, it is also more accurate as it minimizes the rounding effect as compared to the table method. Moreover, we can compute it much faster as we do not need to refer to Future Value Interest Factor (FVIF) table as well as Present Value Interest Factor (PVIF) table.

The table is available here for

Future Value Interest Factor (FVIF): http://arjun.net.np/calculators/fvif_table.php

Present Value Interest Factor (PVIF): http://arjun.net.np/calculators/pvif_table.php?beg=0

Notes:

The question above is extracted from Principles of Corporate II – FIN326, Session: May 2010, Tutorial 3 at Mr.Lim’s class in INTI College Subang Jaya, Malaysia.

Related links and additional readings:

Dividend growth models

http://financialplanningbodyofknowledge.com/index.php?title=Dividend_growth_models

Why a stock valuation process is important in Dividend Growth Model?

http://omniglot.com/onlineinfo/stock/Dividend_Growth_Model.html

Dividend discount model – stock valuation – formula – how to calculate –Subjectmoney.com

http://www.youtube.com/watch?v=1WPbqT0zjys