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While I was reading the examiner report for the previous sitting I came across the following comment from the examiner. ” One common error was not identifying that the dividend growth model can be used to value a company that does not currently pay any dividends. This is incorrect as it can be used if there is an expectation of future dividend payments.”
My understanding of the above scenario is through presenting following example;
Suppose a pay no dividend now and is expecting to pay £10 next year and £ 12 every year thereafter. cost of equity is 15%.
Year 1 = 10 * 0.8695 = 8.695
Year 2 = 12/0.15 = 80 the 80 * 0.8695 = 69.56
Total share price is 69.56 + 8.695 = 78.255.
Not sure if I should have taken to account the growth between year 1 and 2 (12/10)-1 = 20 % but this does not make sense to me as dividend growth model requires current year divided.
Would you please advice me on the above mater?
Thank you very much.
The share price is the present value of future dividends discounted at the shareholders required rate of return – it does not matter when the dividends start to be paid (and dividends will be paid sometime in the future if the company is making profits).
When we use the dividend valuation model, the top bit of the formula is the dividend in 1 years time (which is usually the current dividend plus growth – which is why it is usually written as Do(1+g) ). However if we know the dividend in 1 years time then it is simply D1 on the top of the formula.
I do explain this in my free lectures on the valuation of shares, and it is important because it is common in the exam to have dividends that only start to grow in 2 or 3 years time.
(The lectures are a complete free course for Paper F9 and cover everything needed to be able to pass the exam well)