A:

A company's share price is theoretically determined by the summation of the company's expected future dividends as calculated by the Gordon growth model. The equation for the Gordon growth model, also known as the dividend discount model, is represented by the following:

Present value of stock = (dividend per share) / (discount rate - growth rate)

The equation above treats a stock's present value similarly to a perpetuity, because it is assumed the company's dividend payments are fixed and known throughout the life of the dividend payments. It is easy to see, however, that although a stock price is conceptually determined by its expected future dividends, many companies do not distribute dividends. Many market forces also contribute a company's stock price.

Generally speaking, the stock market is driven by supply and demand, much like any market. When a stock is sold, a buyer and a seller exchange money for share ownership. The price for which the stock is purchased becomes the new market price. When a second share is sold, this price becomes the newest market price, etc.

The more demand for a stock, the higher it drives the price and vice versa. The more supply of a stock, the lower it drives the price and vice versa. So while in theory, a stock's Initial Public Offering (IPO) is at a price equal to the value of its expected future dividend payments, the stock's price fluctuates based on supply and demand.

RELATED FAQS
  1. How is perpetuity used in the Dividend Discount Model?

    Learn about how the concept of a stock perpetuity is used in the basic dividend discount model, which is also known as the ... Read Answer >>
  2. What are the advantages and disadvantages of the Gordon Growth Model?

    Understand the advantages and disadvantages of using the Gordon Growth Model to value a company's publicly traded stock. ... Read Answer >>
  3. What kinds of companies are the best candidates for evaluation using the Gordon Growth ...

    Learn what the Gordon growth model is, how it's used to value a company and what candidates are best suited for evaluation ... Read Answer >>
  4. How can I use the Dividend Discount Model (DDM) effectively for a stock with fluctuating ...

    Find out how the dividend discount model is applied to stocks with irregular dividend payments and how firms with irregular ... Read Answer >>
Related Articles
  1. Investing

    Digging Into The Dividend Discount Model

    The DDM is one of the most foundational of financial theories, but it's only as good as its assumptions.
  2. Investing

    Why Dividends Matter

    Seven words that are music to investors' ears? "The dividend check is in the mail."
  3. Investing

    Valuation Of A Preferred Stock

    Determining the value of a preferred stock is important for your portfolio. Learn how it's done.
  4. Investing

    How Dividends Affect Stock Prices

    Find out how dividends affect the price of the underlying stock, the role of market psychology and how to predict price changes after dividend declaration.
  5. Investing

    Due Diligence On Dividends

    Understanding dividends and how they work will help you become a more informed and successful investor.
  6. Investing

    Using the Dividend Discount Model

    The dividend discount model is a way of applying net present value analysis to estimate the future dividends a stock will pay. Those dividends are then discounted back to their present value. ...
  7. Investing

    The Top 5 Dividend Paying Oil Stocks for 2016

    Discover the top five dividend-paying oil companies for 2016 and what factors contribute to their ability to continue dividend payments.
  8. Investing

    The 3 Biggest Misconceptions of Dividend Stocks

    To find the best dividend stocks, focus on total return, not yield.
  9. Investing

    Put Dividends to Work in Your Portfolio

    Find out how a company can put its profits directly into your hands.
RELATED TERMS
  1. Dividend

    A dividend is a distribution of a portion of a company's earnings, ...
  2. Stock Dividend

    A dividend payment made in the form of additional shares, rather ...
  3. Dividend Growth Rate

    The annualized percentage rate of growth that a particular stock's ...
  4. Dividend Policy

    The policy a company uses to decide how much it will pay out ...
  5. Indicated Yield

    The dividend yield that a share of stock would return based on ...
  6. Cash Dividend

    Money paid to stockholders, normally out of the corporation's ...
Hot Definitions
  1. Nostro Account

    A bank account held in a foreign country by a domestic bank, denominated in the currency of that country. Nostro accounts ...
  2. Retirement Planning

    Retirement planning is the process of determining retirement income goals and the actions and decisions necessary to achieve ...
  3. Drawdown

    The peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted ...
  4. Inverse Transaction

    A transaction that can cancel out a forward contract that has the same value date.
  5. Redemption

    The return of an investor's principal in a fixed income security, such as a preferred stock or bond; or the sale of units ...
  6. Solvency

    The ability of a company to meet its long-term financial obligations. Solvency is essential to staying in business, but a ...
Trading Center