Question

The dividend discount model can be simply stated as the stock is worth the total of all the future dividend payments, discounted back to their present value. Select a publicly traded stock of a multinational enterprise. Calculate the value of the stock using the dividend discount model. Show you calculations and discuss any assumptions you used in this calculation, such as growth. Compare your calculation to the current price of the stock. Is the stock currently trading at, above, or below your value calculation? Research and analyze why the stock may be trading at that value. Would you purchase this stock? Why or why not.

Answer 1

Dividend discount model

Dividend discount model is a way of valuing company’s stock price based on the theory that its stock is worth the sum of all its future dividend payments, discounted back to their preset value. In other words it is used to value stocks based on the net present value of future dividends.

Calculation of stock price using the dividend discount model:

The equation for the dividend discount model is:

Po= Div1 + Div2 +…….Div

        1+r      (1+r)2           r

Key terms here are;

· Po=Present day value of the stock

· Div= Dividends that are paid out to investors in a given

· r= Required rate of return that the investor expect given the risk of the investment

In addition the value of the company whose dividends are growing at a perpetual constant rate is shown by the following function where g is the constant growth rate the company’s dividends are expected to experience for the duration of investment

Constant Growth: Po= Div

   r-g

To understand the model let us consider the following example:

KBC Corporation is paying dividends of Rs2 per share. Investor expects a rate of return of 8% on their investment. Dividends are expected to grow by 5% for one year and then 3% each year thereafter. Applying the discount model using the two formulas above the value of the investment can be calculated in each period.

Year 1: The value of the investment for this time frame is Rs2/1.08=Rs1.85

Year 2: Dividends for this year have grown to Rs2.10per share based on the 5% growth rate. The value of the investment for this time is expected to be worth Rs2.10 (1.08)2=Rs1.80

Constant growth value: According to the constant growth equation listed above the constant growth value of the stock is Rs2.10/(0.08-0.03)=Rs42 per share.

Value of the share of KBC co : the value of a share of stock is calculated by using the two formulas above to calculate the value of dividends in each period i.e

(20.0)/(1.08)+2.10/(1.08)2+2.10/(0.08-0.03)=Rs45.65 per share.

Compare to the value of current share of a stock:

If the share of the stock is trading at less than Rs45.65 per share, the stock is underpriced and they can profit by purchasing it. If the stock is trading at more than Rs45.65 per share, then maybe it is profitable by short selling the security.