In: Finance
Suppose company A has just paid $2 in dividends and company B just paid $2.50 in dividends; which company do you think will have a higher stock price? Analyze and explain how growth expectations would be factored into the analysis
Answer
Let us assume the following few points to reach out conclusions :
The cost of capital (Ke) of both the organisation is same lets say 20%
The Payout ratio of both the organisation is same Let say 100%
As per formula :
Value of Share of Company A would be = D/Ke
= 2/0.2
= $10
Whereas,
Value of share of Company B would be = 2.5/0.2
$ 12.50
Lets further Assume few more things :
The capital base of both the organisations are same let say $10 Milion
Net Income of both the Companies is say $1 Million
Therefore both companies would have ROE of 10% Since ROE = Net Income / Capital Base
Now we need to change the payout ratio of both the companies from 100% to 50%
Then, the growth Rate for both companies would become 5% since sutainable growth rate formula is Retention Ratio * ROE
DPS (D0) of company A is $2 and that of B is $ 2.5
Now as per constant Growth Model share Price would be P1 = D1/ (Ke - g)
Where D1 is D0*Growth and P1 is the share pirce
Incorporating inputs in above formula we get :
Share Price of Company A = 2*1.05/0.2-0.05 = $14
Share Price of Company B = 2.5*1.05/0.2-0.05 = $ 17.50
Hence it can be said that company B will have higher share price than Company A, if other details and factors remains the same.