Stock valuation depends on estimating the growth of a company. Growth refers to the company's total assets increasing over time, whether in the form of more facilities, equipment, land, employees, or profits. Growth depends on an increasingly positive cash flow so the company can fund its expansion. Increased growth also leaves available cash to issue dividends. There are several methods of calculating growth.
Zero-Growth
One is the zero-growth method. If Bill wants to base his purchase decision on dividend performance, he'll plan to hold on to the stock for the profits arising from positive cash flows. The zero-growth valuation method assumes that the dividend rate will stay at its current point. It considers the amount of the dividend by the investor's required rate of return.
For example, Bill is looking at a share of stock that typically pays out a dividend of 25 cents. Bill expects the stock to pay a 2% rate of return going forward.
$0.25 / 0.02 = $12.50
This values the stock at $12.50 per share, so Bill should buy at or below that price. As long as the dividend rate remains stable, Bill could buy a share at or below that value and meet his investment goal.
Constant-Growth
Another valuation method is constant-growth. This valuation method is useful for Bill if stock's dividends are believed to continue to grow at a steady and consistent pace over the long haul. If the current dividend is $1.00 and the next dividend from the share is expected to grow at a 5% rate, the next dividend will be $1.05. This valuation method gives Bill an upper limit purchase price for a stock assuming that a 5% growth rate continues for the foreseeable future.
Two-stage and Nonconstant Growth
There are also the two-stage and nonconstant growth valuation methods. What happens if Bill doesn't expect a stock's dividends to remain constant over a long period of time? The two-stage valuation method considers what a good price is for a stock assuming that dividend rates will fall into two distinct sets before the investor sells the stock. Perhaps Bill is looking at a hot new company that is expected to have large profits at first, but then drop down to a consistent level. Once that first stage is over, Bill plans to sell the stock. The two-stage method would be especially useful in Bill's decision-making in this case.
The nonconstant growth valuation method considers the change in price if the dividends change over time, and the investor continues to hold onto the stock. An example would be if Bill expects a stock's dividends to grow at a rate of 5% per year for the first three years, a 4% rate for the next two years, and a 2% increase each year afterwards. This valuation method helps account for the fact that a company's performance might be expected to ramp up and slow down or have the opposite reaction in the future.
If Bill planned to hold the stock for a while, this would be a more effective method than two-stage valuation. This is especially true since the nonconstant growth method permits for as many stages as the investor wants to calculate.
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