Question

 

1. Estimate a growth rate for your firm's Dividends per Share.
2. Assume a 12.5% discount rate.
3. Calculate an estimated value of a share of the stock using the constant-growth model, also known as the Gordon growth model.
4. Compare and contrast your valuation results with the current share price in the market.
5. Respond to this question: What changes in the variables would be necessary in your valuation to best approximate the market valuation?

Answer 1

According to the Gordon growth model

V0 = Value at time zero

D1 = Dividend of yr 1 [D1 = D0 * (1+g)]

Ke = Cost of equity

g =  constant-growth  

g is calculated by  

g = Return on equity * Retention ratio

Return on equity = EPS/ Current Market Price &   Retention ratio = 1- Payout ratio

Lets, take an example of a company called "Target Corporation (TGT)"

source: https://in.finance.yahoo.com/quote/TGT/key-statistics?p=TGT

Return on equity= 6.36/104.20 & Retention ratio = 1-(41.01%)

Return on equity= 6.1% & Retention ratio = 58.99%

g = 6.1% * 58.99%

g = 3.59%

D1 = D0 * (1+g)

D1 = 2.6 * (1+3.59%)

D1 = 2.70

Ke = 12.5%

V0 = 30.32

  

Our Valuation is 30.32 and the current market price but the current market price is 104.2

The biggest drawback of the model is it assumes a constant growth which in practice is not possible

No business can last till perpetuity

And market is assuming a higher growth than the growth we have calculated in this model because of that the price is more