1.The dividend discount model (DDM) is a procedure for valuing the price of a stock by using predicted dividends and discounting them back to present value; if the value obtained from the DDM is higher than what the shares are currently trading at, the stock is undervalued and vice versa. According to the DDM the price of the stock is Po= Div1/ (r-g) where
Po= is the price of shares, Div1=Dividend next year, r= required rate of return, g=growth rate
The pattern of past and future expected dividends would determine which model is applicable to a particular case. The Two-Stage Model
The two-stage model assumes that the company will experience a period of high-growth followed by a decline to a stable growth period. The first issue to deal with is to estimate how long the high growth period should last. Should it be 5 years, 10 years, or maybe longer? Next the model makes an immediate transition from high growth to low growth which isn’t always realistic.
The Gordon Growth Model
The Gordon growth model can be used to value a company (usually mature) that is in ‘steady state’ with dividends growing at a constant rate that can be sustained forever is a major assumption. model’s greatest strength is its simplicity and is useful because it relies on inputs that are readily available or easy to estimate. Value of Stock = D1
Companies can offer two classes of stock: common and preferred which represents units of ownership. The preferred and common stocks differ in their financial terms and voting/governance rights in the company. While corporate bond is a loan to a company which pays periodic interest payments. As a unit of ownership, common stock typically carries voting rights that can be exercised in corporate decisions. Preferred stock (also called
preference shares or preferred shares) differs from common stock in that it typically does not carry voting rights but as a special equity instrument that has properties of both equity and a debt instrument preferred stocks are legally entitled to receive a guaranteed dividend at a pre-determined interest rate that is specified at the time that the stock is offered before any dividends can be issued to other shareholders. Although the dividend paid on preferred is higher it is taxable and will not vary over the life of the investment. Thus if the company does phenomenally well later due to the development of some successful products, the preferred stock holders will not share in the residual profits. These residual profits are only distributed to the common stockholders Preferred stockholders also enjoy priority distribution of the company’s assets in the event of bankruptcy, while holders of common stock don’t receive corporate assets until all preferred stockholders have been compensated (bond investors take priority over both common and preferred stockholders). Price of Preferred Stock can be calculated as : Price = Dividend/Required Rate of return