Dividend Growth Question

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August 22, 2021 at 4:22 pm #632550
John1998m
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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 = $1.96

This 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 = $1.8051

Does everything seem good?
August 23, 2021 at 10:17 am #632607
John1998m
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Please correct me here!
August 23, 2021 at 4:43 pm #632638
John Moffat
Keymaster
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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.
August 23, 2021 at 7:14 pm #632661
John1998m
- Topics: 62
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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 = $1.96

This 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 = 1.48

Total = $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?
August 24, 2021 at 9:23 am #632717
John Moffat
Keymaster
- Topics: 57
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The market value of the share is indeed $1.8051 – that is correct.

However that is the market value now – the PV of all future expected dividends (writing that it is the MV of a price of year 4 today makes no sense at all).
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