Question

Given that the current Australian share market index value is 5,600 (having fallen significantly from its high level at the beginning of 2020), experts’ views of the likely share market performance over the next year vary between optimistic and pessimistic. Optimists, representing 65% of experts, expect a required return of 12%, a dividend growth rate of 5% and an end-of-year (one year from now) dividend of 455 index points. The pessimists, representing the remaining 35% of experts, argue that the required return will be 8%, the dividend growth rate will be 2% and the end-year dividend will be 318 index points. On the assumption that the respective proportions of optimists and pessimists represent the probabilities that their views will eventuate, calculate the expected percentage return (correct to two decimal places) of the Australian equity market over the next year.

Answer 1

The expected percentage return of the Australian equity market over the next year = 8.57%

Workings:

Note:

Value of Index is calculated using the dividend growth model of valuation and then multiplied with the probability.

Dividend growth model of valuation = Next year dividend / (Required return - dividend growth rate)