Page 184 - DCOM507_STOCK_MARKET_OPERATIONS

Unit 9: Fundamental Analysis 3: Company Analysis

Dividend Discounted Method Notes

Dividend discounted method is based on the premise that the value of an investment is the
present value, its future returns. The present value (PV) calculated by discounting the future
returns, which are divided in the formula, thus, is
D 1 D 2 D 3 D t
PV = + 2 + 3 + ....... t
(1 K) (1 K) (1 K) (1 K)
+
+
+
+
Under the constant growth assumption, this boils down to
t
D
PV =
−
K g
K = Discount rate
g = Growth rate
DPS = EPS × (1 – b)
DPS = Dividend Per Share

b = Proportion of earnings retained such that (1 – b) is the dividend payout
Substituting the above in the formula, it becomes

−
EPS (1 b)
−
Kg
On the basis of the above model, the following inferences can be drawn:
1. Higher the EPS, other things like b, k, g remaining the same, higher would be value of the
share.
2. Higher the b, retention rate, or lower the 1–b i.e., g remaining the same, higher would be
value of the share.
3. Higher the k, i.e. discount rate, other things like b, g remaining the same, higher would be
value of a equity.

4. Higher the growth rate, other things like EPS, b, k remaining constant, higher would be
value of the share.
These inferences clearly highlight the effect of different variables on the future price of equity
shares.

!
Caution When applying this approach, one has to be careful about using discount rate k.

A higher value of discount could unnecessary reduce the value of share and equity, while a
lower value unreasonably increase it; this will induce a complication to invest/disinvest the
shares. A discount rate is based on the risk rate and risk premium. That is
Discount risk free rate + risk premium
K = r + r
1 2
Where r = risk free rate of return
t
r = risk premium
2

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