Expected Dividends as the Basis for Stock Values

by Maestri

Stock prices are likewise determined as the present value of a stream of cash flows, and the basic stock valuation equation is similar to the bond valuation equation. What are the cash flows that corporations provide to their stockholders? First, think of yourself as an investor who buys a stock with the intention of holding it (in your family) forever. What about the more typical case, where you expect to hold the stock for a finite period and then sell it—what will be the value of ˆP0 in this case? Unless the company is likely to be liquidated or sold and thus to disappear, the value of the stock is again determined by Equation 5-1. To see this, recognize that for any individual investor, the expectedcash flows consist of expected dividends plus the expected sale price of the stock.

However, the sale price the current investor receives will depend on the dividends some future investor expects. Therefore, for all present and future investors in total, expected cash flows must be based on expected future dividends. Put another way, unless a firm is liquidated or sold to another concern, the cash flows it provides to its stockholders will consist only of a stream of dividends; therefore, the value of a share of its stock must be established as the present value of that expected dividend stream.
The general validity of Equation 5-1 can also be confirmed by asking the following question: Suppose I buy a stock and expect to hold it for one year. I will receive dividends during the year plus the value ˆP1 when I sell out at the end of the year. But what will determine the value of ˆP1? The answer is that it will be determined as the present value of the dividends expected during Year 2 plus the stock price at the end of
that year, which, in turn, will be determined as the present value of another set of future dividends and an even more distant stock price. This process can be continued ad infinitum, and the ultimate result is Equation 5-1.7

Taken From : Five-Minute MBA – Corporate Finance

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