An Internally Consistent Approach to Common Stock Valuation

International Business & Economic Research Journal, Vol. 1, No. 3

9 Pages Posted: 25 Jun 2002

See all articles by Larry R. Gorman

Larry R. Gorman

California Polytechnic State University

Abstract

A modern corporate finance curriculum typically extends the one-stage Gordon (1962) dividend discount model into a multi-stage environment. In such instances, each regime of constant dividend growth defines a distinct stage. The rate of sustainable dividend growth in each stage is typically determined by specifying the firm's return on asset (ROA) and plowback (PB) ratios in each stage, and then computing the implied dividend growth rate as g = ROA . PB.

In a two-stage problem, current convention typically advocates that the first dividend in the second stage should equal the last dividend in the first stage, multiplied by 1 + g2, where g2 is the growth rate of dividends in the second stage. We show that the dividend stream generated with this methodology is inconsistent with the ROA and plowback assumptions used previously to compute g2. The implication is that the conventional pricing methodology results in stock valuations that are inconsistent with ROA and PB assumptions. For a common textbook problem, we demonstrate pricing errors on the order of 30%. In order to address the issue, we provide an alternative pricing methodology that results in valuations that are consistent with underlying assumptions.

Pedagogically, when the proposed approach is contrasted with the traditional approach, the student is forced to develop a deeper fundamental understanding of how stock valuation relates to (i) operational efficiency, (ii) dividend policy, and (iii) the economic environment in which the firm competes.

Keywords: Asset Pricing, Valuation, Stock Pricing, Gordon Model, Investments, Stock Selection, Stock Market

JEL Classification: A22, A23, D46, G12, G30, G31, G35

Suggested Citation

Gorman, Larry, An Internally Consistent Approach to Common Stock Valuation. International Business & Economic Research Journal, Vol. 1, No. 3, Available at SSRN: https://ssrn.com/abstract=314939 or http://dx.doi.org/10.2139/ssrn.314939

Larry Gorman (Contact Author)

California Polytechnic State University ( email )

College of Business
Department of Finance
San Luis Obispo, CA 93407
United States
805-756-1312 (Phone)
805-756-1473 (Fax)

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