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- This topic has 3 replies, 3 voices, and was last updated 1 year ago by John Moffat.
- October 25, 2020 at 11:12 am #593081joevassalloParticipant
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Can you please explain the logic behind the following statement that I read from one of the text books:
“The current dividend is the only factor that is known with certainty.
Therefore, there is no limitation of using the DVM to calculate the market value of a share.
However, the shareholders required rate of return, and the future expected dividend growth rate, are both not known with certainty, while the expected growth in dividends may not be constant, so there will be limitations using the DVM to calculate the market value of a share”.
It is the last sentence which I am not clear about when it mentions limitations?
Thank you.October 25, 2020 at 5:28 pm #593104John MoffatKeymaster
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Have you not watched my free lectures?
In theory the market value of a share is the present value of the expected future dividends discounted at the shareholders required rate of return (and the dividend valuation model formula is calculating the present value).
Given that we cannot know what future dividends the shareholders are expecting with certainty, and nor can we know what the shareholders required rate of return is with certainty, then we cannot be certain of the result of the dividend valuation model.October 20, 2021 at 10:00 am #638579zakanyaMember
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if i have growth only expected from year 2 onwards? the dividend is $2 the growth is 4% and Ke is 10%. i got 34.67 i am not sure how the answer gets to 33.33. Please show me how
Thank youOctober 20, 2021 at 4:22 pm #638615John MoffatKeymaster
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The question as you have typed it is not clear. I do not know where you found the question, but I do not think you have typed it out in full.
The reason it is not clear as it does not state whether there will be a dividend payable at time 1 or not. It would be normal to assume that the dividends payable at time 1 and time 2 are both $2, and that from time 3 onwards it is $2 growing at 4% per annum.
You have arrived at $34.67 by using the formula, but the formula gives the MV now if the current dividend that has just been paid is $2 and the first dividend is in 1 years time, and dividends are growing at 4% every year (so the dividend at time 1 would be 2 x 1.04, and so on), which is not the case here.
The answer you quote is only correct if we assume that the dividend in 1 years time is $2 and that the dividend in 2 years time is $2 x 1.04 and that it continues growing at 4% each year thereafter. (But that is not what the question as you have typed it says!).
If we go forward 1 year in time, the applying the formula to the dividends from year 2 onwards gives a value of $34.67. However this is the PV in 1 years time which then needs discounting for 1 year at 10% to get a PV ‘now’. The market value if the PV of all future dividends and so we also need to add the PV of the dividend of $2 in 1 years time.
So the MV will be (34.67 + 2) / 1.1 = $33.33
This type of question is common in the exam and I explain what is happening in detail in my free lectures on the valuation of securities.
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