Question

As an investor in the equity market you become aware of investment opportunity in 3

corporates. Assuming that the cost of equity is 8%, compute the fair value of X Limited,

Y Limited and Z Limited using the Dividend discount model.

a. Given the history of the company, X Limited is expected to pay a uniform dividend of Rs. 5.00 per share.

b. Being in the IT Industry, Y Limited is expected to pay a dividend of Rs. 4.00 per share

and an increase of 5% year on year thereafter.

c. A pharmaceutical company, Z Limited has been paying a dividend of Rs. 2.00 over for

the last 3 years. The company is expected to do extremely well and increase the dividend

pay-out by 7% year on year. This year the dividend expected is Rs. 8.00.

Additionally, what is the biggest lacuna in the Dividend Discount Model in valuing

stocks? Give an example to explain.

Answer 1

Cost of Equity = 8%

 

Part A

Dividend per share = 5

 

Part B

Dividend per share expected = 4

Constant Growth rate = 5%

 

Part C

Last Dividend = 2

Expected Dividend = 8

Constant Growth rate = 7%

 Solution

Part A

Constant Dividend

Value of stock = Dividend per share ÷ Cost 

of Equity

$=\frac{5}{8\%}\\\frac{5}{0.08}\\ = 62.50$

Part B

Using Constant Growth Model,

Value of stock = Dividend per share

 expected ÷(Cost of Equity − Growth Rate)

$=\frac{4 }{(0.08− 0.05)}\\ = 133.33$

Part C

Using Constant Growth Model,

Value of stock = Dividend per share 

expected ÷(Cost of Equity − Growth Rate)

$= \frac{8 }{ (0.08- 0.07)}\\ = 800.00$

stocks based on the net present value of the future dividends.