Question

This year Newage Energy Bhd paid its shareholders an annual dividend of $3 a share. It is expected that the company's annual dividends will grow at the rate of 10% per year for each of next 5 years and then level off and grow at the rate of 6% a year thereafter.

A) Use the variable-growth dividend valuation model (DVM) and the required rate of return of 12% to find the intrinsic value of this stock.

B) Assuming another scenario that after year 5, dividends stop growing altogether (i.e. for year 6 and beyond, g=0). Use all the other information given to find the stock's intrinsic value.

C.Contrast your two answers above and conclude on your finding in the context of how dividend growth is important to this valuation model.

Answer 1

A. Formula for value of stock using dividend valuation model :-

Value of Stock = Dividend/Discount Rate - Growth Rate

This formula is used when the dividene grows in perpetuity. Here, dividend will grow in prepetuity after 5 years. So, we need to calculate the value of stock at the end of 5th year first and than discount it to year 0.

So, Dividend at the end of 5th year = 3 * (1.1)^5

= 4.83

So, value of stock at the end of 5th year = 5.12 (4.83*1.06)/(12% - 6%)

= $85.33

Now, value of stock at current prices is = 85.33/1.12^5

= $48.42

B. Value of stock if the dividend stops growing after 5 years.

Value of stock =  4.83/(12%) Since no growth after 5 years.

= $40.25

Now, value of stock at current prices is = 40.25/1.12^5

= $22.84

C. Intrensic value of stock is higher where there is constant growth in the dividend valuation. So, valuation of stock will be higher where there is constant growth, and so dividend growth is very important.