Abstract
This paper presents models of equity valuation where future dividends are assumed to follow a generalized Bernoulli process consistent with the actual dividend payout behavior of many firms. This uncertain dividend stream induces a probability distribution of present value. We show how to calculate the first moment of this distribution using functional equations. As well, we demonstrate how to calculate a confidence interval using Monte Carlosimulation. This first moment and interval allows an analyst to determine whether a stock is overor under-valued.
Highlights
IntroductionDividend discount models are a common feature of most introductory finance textbooks
This paper presents models of equity valuation where future dividends are assumed to follow a generalized Bernoulli process consistent with the actual dividend payout behavior of many firms
We demonstrate how to calculate a confidence interval using Monte Carlo simulation
Summary
Dividend discount models are a common feature of most introductory finance textbooks. Gordon assumes that the dividend stream will increase at a constant geometric growth rate in perpetuity. All of them assume that future dividends will follow a fixed, mechanistic path. These deterministic dividend streams are not really consistent with the payout policies of most firms. A firm will hold a dividend constant until such time as it can see itself being able to increase it and maintain the increase. Such dividend streams are characterized by uncertainty in that an analyst would never be certain when and by how much a dividend was going to increase. This allows an analyst to compare the current market price of the stock to this moment and interval and in so doing determine whether or not the share is over- or under-valued
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