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I am Julia Martin and I am going to tell you everything you need to know about dividend growth rate model to solve your assignments.
The dividend growth model is a valuation model. Using this model, the financial analysts and investors calculate the fair value of a stock and then decide if the stock is worth investing in or not.
An important point you should remember here is that this model operates on the assumption that the dividends grow annually. That can be either at a stable rate constant for a long time or different rate is broken into smaller time periods.
See, whenever the company is paying dividends to the shareholders, it is available on the stock market. You know that, right? So, when a potential investor is looking to invest in a stock, they evaluate their options. They check if the stock’s dividends will grow in the near future or not and will the investor get a return for their investment?
Do you understand this till here?
So, there are two terms that we use in a dividend growth rate model. The first one is undervalued. An undervalued stock means the present value of the stock is more than the market value of the stock.
The other one is overvalued. It means that the market values the stock for more than what it is worth. Or, the present value of the stock is less than the market value of the stock.
You do that by calculating the firm’s expected dividends and at what rate do they grow annually.
This is the formula to calculate the current stock price, where -
P = current stock price
D = value of the dividend of the next year
r = constant cost of equity capital for that company. In other words, the rate of return
g = constant growth rate in perpetuity expected for the dividends
Of course, I can. You will understand everything quite clearly with an example.
Imagine a company called Corporation A declares that it provides an annual dividend of $3 per share for the year. I am a financial analyst and Mr X wants me to calculate the fair value of the company’s stock and tell if the investment is worthwhile or not.
I dig into the company’s records and see the past trends to see that the dividends for Corporation A grow at a constant rate of 6% in perpetuity. Also, the previous data reveals that the rate of return of the company is 13%.
Therefore, the price of the stock is
D = $3
r = 13%
g = 6%
P = $3/(13%-6%) = $3/7% = $42.86
This price, $42.86 is the present value of the stock as per the constant dividend growth rate model. If the stock market is selling the stocks of Corporation A for a price lower than $42.86, then the stock is undervalued and will be a good investment for Mr X.
If the market price of the stock is greater than $42.86, then the stock is overvalued and an unwise decision for Mr X.
There are a few assumptions that govern this model. They are -
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Julia Martin has been a teacher, private academic expert and has held the position of an accounting manager at a firm in Melbourne. She joined My Assignment Services as an accounting assignment writing expert and have grown since then to become one of the best accounting assignment experts in the assignment help through guided sessions industry. She has worked with students of several universities and has even aided students from Singapore, the United Kingdom, etc. with her expert consultation. She writes blogs for students to help them understand the accounting assignments’ concepts, principles and theories.
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