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I thought it might be worth going through the basics of share valuation, focusing on a class of techniques based on dividends, taught to professional analysts.
Dividend valuation models (DVMs) are based on the premise that the market value of ordinary shares represents the sum of the expected future dividend flows, to infinity, discounted to present value.
The only cash flows that investors ever receive from a company are dividends. This holds true if we include a ‘liquidation dividend’ upon the sale of the firm or on formal liquidation, and any share repurchases can be treated as dividends.
Of course, an individual shareholder is not planning to hold a share forever to gain the dividend returns to an infinite horizon. An individual holder of shares will expect two types of return:
a income from dividends, and
b a capital gain resulting from the appreciation of the share and its sale to another investor.
The fact that the individual investor is looking for capital gains as well as dividends to give a return does not invalidate the model. The reason for this is that when a share is sold, the purchaser is buying a future stream of dividends, therefore the price paid is determined by future dividend expectations.
To illustrate this, consider the following: a shareholder intends to hold a share for one year. A single dividend will be paid at the end of the holding period, “dividend-one”, and the share will be sold at “price-one” in one year.
To derive the value of a share now at time 0, “price-zero”, we need to discount each of the future cash flows the investor will receive, that is, dividend-one and price-one.
The required rate of return includes an allowance for the risk class of the share, call this the “discount rate”.
Price-zero (current value) = (dividend-one ÷ (1 + discount rate)) plus (price-one ÷ (1 + discount rate))
EXAMPLE
An investor is considering the purchase of shares in Oak plc. At the end of one year a dividend of 22p will be paid and the shares are expected to be sold for £2.50. How much should be paid if the investor judges that the rate of return required on a financial security of this risk class is 9 per cent?
ANSWER:
Price-zero (current value) = (dividend-one ÷ (1 + discount rate)) plus (price-one ÷ (1 + discount rate))
Price-zero = 22p/(1 + 0.09) + 250p/(1 + 0.09) = 20.2p + 229.4p = 249.6p
The dividend valuation model to infinity
The relevant question to ask in order to understand DVMs is: where does price-one come from?
The buyer at time one estimates the value of the share based on the value of future income given the required rate of return for the risk class.
So if the second investor expects to hold the share for a further year and sell at time 2, two years hence, for “price-two”, the price-one (in one year from now) will be:
Price-one = (dividend-two (in two years) ÷ (1 + discount rate)) plus (price-two ÷ (1 + discount rate))
Returning to the price zero equation we are able to substitute discounted dividend-two and price-two for price-one. Thus:…….
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