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CH.5/ VALUATION: COMMON STOCKS Common Stock Valuation Valuing common stock is more difficult than valuing bonds or preferred stock, which both have a known, steady payment. With common stock, questions about : right approach , right planning horizon and dividend growth patterns . BASIC MODEL: Growing Perpetuity Model Suited for companies in the mature stage of their life cycle. Why is model a close approximation of stock value? Time value of money concepts: While a company really will not have perpetual cash flows at the same growth rate, note that future dividends will be discounted at an exponentially decreasing present value factor, so more distant dividends provide less and less of the total value of the stock. So even if investors don’t hold a stock forever, the later cash flows have less value. Maturity and Stable Growth: It is also true that a company’s dividends do not grow at the same rate forever. However, for a mature, stable company this may be a close enough approximation. Typically as a company matures , it will settle into a low, long term growth around the rate of inflation. LIMITATIONS OF CONSTANT GROWTH MODEL Dividends may not really grow at a constant rate The discount rate must be greater than the growth rate for the model to work Variable Growth Model : Applies to Young Fast-Growing Firms Analysts often use a variable growth model, when a company has a different dividend rate before it settles into its steady growth. What about firms that do not pay dividends? The notion of liquidating dividend .
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While the model can’t be used, the model is still valid. Even if a firm does not pay a dividend and has no intention of declaring a dividend, at the very least it will have a liquidating dividend. At some point, when the company dissolves or is acquired, it will pay stockholders their share of
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