Question

one of the most common methods of trying to find the correct value for a stock is the use of the Gordon model also called the dividend discount model. what are the assumptions underlying he model? can any these assumptions be relaxed without compromising the effectiveness of the pricing model? if so which ones?

discuss how you can value a non-dividend paying stock

One of the most common methods of trying to find the correct value for a stock is the use of the Gordon model, also called the dividend discount model. What are the assumptions underlying hemodel? Can any of these assumptions be relaxed without compromising the effectiveness of the pricing model? If so, which ones? Discuss how you can value a non-dividend paying stock.

Answer 1

(1): The assumptions that are used in the Gordon model are:

• The dividend will have a stable growth rate
• The rate of return will also be stable
• Rate of return>growth rate

Yes, the first 2 assumptions can be relaxed without compromising the effectiveness of the pricing model. The dividends need not have a stable growth rate and even if dividends have different growth rates in different years the present value concept can be applied easily to compute the present value of all future dividend payouts. Same is the case with the second assumption which states that rate of return should be stable. Even if rate of return is different in different years then the present value concept can easily be applied and present value of all future dividends can be computed easily.

(2): To value a non-dividend paying stock we can use either the free cash flow valuation model or the residual income based model.

In the free cash flow valuation model: intrinsic value of a stock = present value of its free cash flow. Free cash flow is the net cash flow that is left over for distribution to stockholders and debt-holders in each period. For discounting WACC (weighted average cost of capital) is used.

In the residual income valuation method: intrinsic value of a stock = present value of future residual incomes that are discounted at the appropriate cost of equity.

Residual income = net income – (equity capital * cost of equity)