Common Stock Valuation on Dividend Stocks

by Alexis Lawrence

When investing in stocks, it is not clear how much money can be made. This is because stocks differ from bonds, which have definite maturities and cash flows you know about in advance. Before investing in dividend stocks, you can do a common stock valuation to get an idea of whether or not it is a good investment choice for you. Such a calculation is only an estimate since no one can predict the future of the market.

Defining Stock Valuation

Stock valuation is the calculation process used to determine the fair market value of a particular stock. You can do stock valuation for any type of stock. The calculation is generally done to predict future value or profitability. Calculating stock valuation can be helpful in determining which stocks to buy.

Defining Dividend Stocks

Dividend stocks are those that normally pay out a dividend to investors. Such stocks are generally stable, slow-growth investment vehicles that offer steady dividend payments. Usually these stocks are from well-established companies and offer a relatively low-risk investment choice. While dividend stocks do normally issue dividends, they are never guaranteed to pay out dividends.

Stock Valuation Formula

The formula used to calculate the common stock valuation is called the Gordon growth formula. It is also sometimes referred to as the constant growth formula. This formula assumes that the company grows at a steady, constant rate for the rest of its existence. The formula is Po = D1 / ( Ks - G ) where Po stands for the price, D1 stands for the next dividend, Ks stands for the rate of return and G stands for the growth rate. D1 is determined by the formula D1 = D0 (1 + G), where D0 is the last dividend.

How To Perform Calculation

The first step in the calculation is to solve for D1. For an example, assume that the last dividend was $3, the growth rate is 5 percent and the rate of return is 10 percent. Using the example to solve for D1, it would be D1 = $3 (1 + 0.05) which would mean that D1 = $3.15. Now that you have D1, you can solve for the valuation. Using the same example, it would be Po = $3.15/(10%-5%) which would mean that Po = $63. The result means that you must pay $63 for the common stock to get a 10 percent rate of return, assuming that the company grows by 5 percent each year.

References

About the Author

Alexis Lawrence is a freelance writer, filmmaker and photographer with extensive experience in digital video, book publishing and graphic design. An avid traveler, Lawrence has visited at least 10 cities on each inhabitable continent. She has attended several universities and holds a Bachelor of Science in English.