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Valuation of stocks, for example shares, is more difficult than valuation of bonds. There are two main reasons for this. Stocks do not have a finite maturity like bonds, thus, the only way to redeem stock investment is by transferring the rights and obligations attached to those shares to another person by selling shares. Unlike stocks, bond investments are paid out to bond holders upon reaching maturity. Stocks future cash flows cannot be predicted and determined early in advance, as, for example, future dividends on stocks depends on profitability of company and may or may not be paid to the shareholder upon company’s Board’s decision. Interest earned on bonds is fixed and is paid after specified period of time. Therefore, on the basis of the two reasons above, when valuing stocks, assumptions must be made regarding the dividends structure. A constant dividend growth model assumes that future dividends are expected to grow at a constant rate. The method applied in valuing stocks, where a constant rate of dividend growth exists, is the one referred to as constant growth model method, or dividend discount model, or Gordon growth model method. Constant growth model can be viewed as a method of finding the intrinsic value of the stock. It is done on the basis of predicted future dividends, which are expected to grow at a constant rate. These expected dividends are discounted to present value to get the current stock value. The growth model is based on the following three parameters, which are used in stock valuation. The parameters include current or expected dividend, dividend growth rate, and required rate of return.
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Dividends Growth Rate
Dividends growth rate can be defined as the accumulated annual growth rate of the company’s dividends. From the previous case companies, we are further provided with the following information:
For ITC Holding Corporation, a Chicago-based company, the dividend per share payout ratio for the financial year ended Dec 31, 2010 was $0.5, while DPS for the year ended December 31, 2011 was $0.55. The market price for ITC Corporation shares is $30, and the shareholders anticipated rate of return on their investment of 12%.
Entergy Corporation Ltd, a listed company with headquarters in Baltimore, has been paying out dividends to its shareholders at a constant growth rate. During the financial year ended March 31, 2007, shareholders were paid $0.5 per share, and for the fiscal 2012 ended March 31, 2012,, the company paid its shareholders $0.6 per share in dividends. The company’s shares are currently trading at $8 at the bourse, and the shareholders expect the rate of return of 10%.
On the basis of the two cases above, following calculations are:
The Annual dividend growth and future share price of each company.
ITC Holding Corporation:
Dividend growth rate = DPS yr 2010 – DPS Yr 2011/DPS Yr 2010=0.55 – 0.5/0.5=10%
Determination of stock/share price
The value of a stock growing at a constant annual rate can be determined by utilizing the following equation: Stock price = Expected Dividend per share in the current financial year/required rate of return – the annual dividends growth rate Share price
(Po) = D1/r – g or Do (1 + g)/r – g
Where; Po = the stock price at time 0
Do = the Current dividend,
D1 = the expected Dividend at time 1
g = the annual dividends growth rate
r = the shareholders required rate of return on the stock,
And required rate of return should be greater than annual dividends growth rate, i.e. r > g. Po (ITC Holding) = 0.55/0.12 – 0.1= $27.5
Entergy Corporation:
Dividends annual growth rate = $0.6 - $0.5/$0.5=0.2/5=4%
Stock price of Entergy Corporation = 0.6/0.1 – 0.04=$10
From the computations above, it is quite evident that ITC Holding Corporation has a better annual dividend growth than Entergy Corporation. Due to the fact that ITC Corporation dividends growth is higher than that of Entergy, its shares seem to be in demand, hence, they are overvalued. The higher dividend payout to ITC Holding Corporation shareholders is a factor that has contributed to its stock being overvalued. The stock of Entergy is undervalued by the market, most likely due to of the lower dividend growth rate. My advice to prospective investors is to purchase Entergy Corporation’s stock, as it is undervalued by the market forces; hence, there is a high likelihood of the Entergy’s stock price to rise up in the future. However, valuing stocks using the Gordon growth model will only be valid when the annual rate of dividend growth remains constant. Also, the required rate of return on the stocks must be greater than the annual rate of dividends growth for this model to be applied.