How to Calculate Stock Price Perpetuity
Original post by Ryan Menezes of Demand Media
When a company's stock pays a dividend stream, investors treat income as a perpetuity -- an infinite stream of cash flow payments. The dividends are expected to increase over time, so investors consider the stream as a constant-growth perpetuity. The stock's value is the dividends' total value over time. Although the payments continue indefinitely and even grow continuously, the total value is finite. This is because inflation reduces future payments' worth, reducing their present value.
Decide on a discount rate, which determines the present value of future payments. The most common source for discount rates is the U.S. Treasury borrowing rate. For this example, assume a borrowing rate of 12 percent.
Subtract the dividend growth rate from the discount rate. For example, if the stock offers a growth rate of 8 percent, subtract 0.08 from 0.12, which produces a rate of 0.04, or 4 percent.
Divide the dividends' initial payment amount by this rate. For example, if the stock's first payment is $25, divide $25 by 0.04, which yields a price of $625. This is the stock's price if you treat is as a constant growth perpetuity.
Tips & Warnings
- The formula works as long as the discount rate exceeds the dividend growth rate. If not, returns will perpetually increase, and the stock will have an undefined value into perpetuity.
- "Essentials of Managerial Finance"; Scott Besley, Eugene F. Brigham; 2007
- "Management Economics: An Accelerated Approach"; William G. Forgang, Karl W. Einolf; 2007
About the Author
Ryan Menezes is a professional writer and blogger. He has a Bachelor of Science in journalism from Boston University and has written for the American Civil Liberties Union, the marketing firm InSegment and the project management service Assembla. He is also a member of Mensa and the American Parliamentary Debate Association.
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