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Sir, you explained in Valuation of Equity – example 7 where you calculated MV of $1.75 but I am trying to attempt the same question with the addition of Year 4.
[Question]
Let’s say that the dividend remains constant at 20c for two years but thereafter it grows at 4% for two years.[Answer]
Dividend Valutaion Model:
P2 = 20 (1.04)^2 / 0.15 – 0.04
P2 = $1.96This gives me the market value at Year 2; And we discount it back to Year 2 Discount Factor;
PV = 20 / (1.15)^2 = 0.1739
PV = 20 / (1.15)^2 = 0.1512
PV = 1.96 / (1.15)^2 = 1.48
Total = $1.8051Does everything seem good?
No, it is not correct.
Had the dividend been growing at 4% in perpetuity after the 2 years then it would have been correct. The dividend valuation model is for dividends growing in perpetuity.
If it is only growing for 2 years then you need to calculate the dividend at time 3 and time 4 and then discount them. However that would never happen in the exam – there couldn’t be the case where dividends were expected to suddenly stop! 🙂
(There is a typing errors in the first line of your final workings. It should read PV = 20/1.15 and not 20/(1.15)^2. However you have calculated it correctly as 0.1739.
Let me rephrase the question because I didn’t mean that dividend will stop after 2 years but rather mean that how can we calculate the share price of year 4.
[Question]
The dividend remains constant at 20c for two years but thereafter it grows at 4%. BUT we need to calculate the MV of share price of year 4 (rather than year 3 like in previous question).[Answer]
Since Dividends will grow after year 2 in perpetuity DVM formula therefore becomes relevant.DVM:
P2 = 20 (1.04)^2 / 0.15 – 0.04
P2 = $1.96This gives me the market value of Year 4; And we have to discount it back to Year 2 Discount Factor;
PV = 20 / (1.15)^1 = 0.1739
PV = 20 / (1.15)^2 = 0.1512
PV = 1.96 / (1.15)^2 = 1.48Total = $1.8051 (at Po)
So the Market Value of a Share Price of Year 4 would be $1.8051 TODAY (at Year 0)
Is it correct NOW?
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