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Assume you are using the dividend growth model to value stocks. If you expect the market rate of...

Question:

Assume you are using the dividend growth model to value stocks.

If you expect the market rate of return to increase across the board on all equity securities, then you should also expect the:

a. market values of all stocks to increase, all else constant.

b. market values of all stocks to remain constant as the dividend growth will offset the increase in the market rate.

c. market values of all stocks to decrease.

d. dividend-paying stocks to maintain a constant price while non-dividend paying stocks decrease in value.

e. dividend growth rates to increase to offset this change.

Dividend Growth Model:

This question calls for a basic understanding of a dividend growth stock valuation models. These models establish a fair value for a stock based on the present value of expected future dividends. A number of variables influence the discounting process, including the actual dividend amounts projected and the required rate of return for the stock.

Answer and Explanation:

The correct answer is "c. market values of all stocks to decrease."

Explanation:

A commonly employed dividend growth model is the constant growth dividend discount model (DDM), which is also referred to as the Gordon Growth Model. The formula for the DDM, which assumes constant growth in dividends, is provided below.

P0 = D1/(r - g)

where,

  • P0 = intrinsic value of stock
  • D1 = dividend payment one year from today
  • r = discount rate
  • g = growth rate

As indicated in the model, the required rate of return is a component of the denominator. So, an increase in this variable will surely reduce the resulting stock value (holding all else constant).


Learn more about this topic:

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The Dividend Growth Model

from Finance 101: Principles of Finance

Chapter 14 / Lesson 3
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