When a company's stock pays a dividend stream, investors treat income as a perpetuity -- an infinite stream of cash flow payments. The dividends are expected to increase over time, so investors consider the stream as a constant-growth perpetuity. The stock's value is the dividends' total value over time. Although the payments continue indefinitely and even grow continuously, the total value is finite. This is because inflation reduces future payments' worth, reducing their present value.
1. Decide on a discount rate, which determines the present value of future payments. The most common source for discount rates is the U.S. Treasury borrowing rate. For this example, assume a borrowing rate of 12 percent.
2. Subtract the dividend growth rate from the discount rate. For example, if the stock offers a growth rate of 8 percent, subtract 0.08 from 0.12, which produces a rate of 0.04, or 4 percent.
3. Divide the dividends' initial payment amount by this rate. For example, if the stock's first payment is $25, divide $25 by 0.04, which yields a price of $625. This is the stock's price if you treat is as a constant growth perpetuity.
- The formula works as long as the discount rate exceeds the dividend growth rate. If not, returns will perpetually increase, and the stock will have an undefined value into perpetuity.
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