Dividend Discount Model - Example

Assume Company A is currently paying

$1 per share in dividends and
investors expect the dividends to grow
at a rate of 7% a year for the
foreseeable future.

If investors require a return of 15% a

year for investment at this level, what
is share price of Company A ?
10-2
Dividend Discount Model - Example

D1 =D0 (1+g)
=$1.00 X (1+0.07)
=$1.07

D1
P0
k g
Po = $1.07 / (0.15-0.07)
= $13.38

10-3
Dividend Discount Model
Implications of constant growth
Stock prices grow at the same rate as
the dividends
Stock total returns grow at the required
rate of return
Growth rate in price plus growth rate in
dividends equals k, the required rate of
return
A lower required return or a higher
expected growth in dividends raises
prices 10-4
Dividend Discount Model - Example

Price today as previously determined

= $13.38

D1
P0
kg
Price for next year
= $1.07 (1.07) / (0.15-0.07)
= $14.31

Change in estimated value

= (14.31 13.38) / 13.38
= 7%
10-5
Dividend Discount Model - Example

Assume that dividends of Company A were to

grow at a rate of 10% a year instead of 7%:

The price will become:

D1 =$1.00 X (1+0.10)
=$1.10

Po = $1.10 / (0.15-0.10)
= $22.00 (previously was 13.38)

10-6
Dividend Discount Model

See the relationship of the components in the formula ?

D1
P0
kg

When D1 is Higher, Po will be Higher

When K is Higher, k-g will be higher, therefore Po Lower
When g is Higher, k-g will be lower, Therefore Po Higher

10-7
Exercise
Share price = $8.00
Last dividend = $1.20
Constant growth = 5%

What is the required rate of return on

this share?

Will you buy this share if your cost of

capital is 15%
10-8
Exercise - Answer
8.00 = 1.20(1.05) / R 0.05
8.00 = 1.26 / R 0.05
R 0.05 = 1.26 / 8.00
R = 0.1575 + 0.05
R = 0.2075 = 20.75%

Since return of 20.75% is higher than

the 15% cost of capital. YES ! BUY IT !
10-9