The main objective behind investment in shares is to get dividends and earn capital gains over the periods due to increase in the market price of these shares. Literally in the investment decisions of shares the concept of undervaluation and overvaluation works. A mindful investor always prefers to invest in undervalued shares which mean intrinsic value of a share is greater than its market price and investors foresee more benefits in future. In case of overvaluation a cognizant investor chooses to sell the stock because true value or intrinsic value of a share is less than its market price and he/she gains from selling the share and using the proceed in more advantageous opportunities.
The question arises what does true or intrinsic value of a share means. Ideally true value of a share is the present value of the dividends in years to come which is computed by keeping in view the expected growth pattern of the dividend in future. Under the dividend growth pattern the share valuation models are explained as under:
Zero-Growth-Model (No growth in dividend per share in future)
In case the company is offering constant dividend per share and its policy of constant dividend is expected to remain continue in future the intrinsic value of a share is simply the present value of perpetuity (constant dividend per share) discounted at required rate of return.
Illustration
A firm pays dividend of $4 regularly over the years and declares that the same policy will continue for an indefinite time period. Investors’ required rate of return is 15%.
Requirement: Please compute price per share
Answer:
Price per share = $4 / 0.15 = $26.67
Steady-Growth- Model (Constant growth in dividend per share in future)
Steady-Growth-Model also called Gordon Stock Valuation Model refers the computation of value of a share in the situation where constant percentage growth prevails. In other words companies have a declared parentage increase in dividend per share in future years. The current market price is computed through dividing the expected dividend per share in next period by the difference of required rate of return and constant growth rate.
Illustration
A hypothetical company used to pay dividend at steady growth rate of 5% regularly over the last 4 years and declares that the same policy will continue for an indefinite time period. In the year 5, $10 dividend per share is expected. Investors’ required rate of return is 15%.
Requirement: Please compute price per share
Answer:
Price per share = $10 / 0.15 - 0.05 = $100
Uneven-Growth-Model (Irregular growth in dividend per share in future)
It is not common in practice that companies operate with zero growth or constant growth in dividends. Factually growth rates in dividend change after some time in future. In this case computation of the value of one share in the current period becomes complex. The process of computation is as under:
· In the first step present values of the dividends per share are computed over the periods the dividend growth rate is expected to keep on changing.
· A sum total is ascertained of the present values of each year dividend per share computed in step 1.
· Dividend per share is computed for the year from which the growth is expected to be at the constant rate.
· Present value the value of share computed in step 3 is determined.
· Sum the values calculated in step 2 and 4.
· The resultant value in step 5 is the value per share in current year.
Illustration
Suppose a company pays dividend per share of $5 currently and is expected to grow at 8% for the next 4 years. After that growth rate will decrease to 4% forever.15% is the required rate of return.
Requirement: Please compute price per share
Answer:
Present value of dividends per share for first four years.
| End of Year | Dividend Per Share (8% Growth) $ | PVIF 1 to 4, 15% | Present Value $ |
| 1 | 5.4 | 0.87 | 4.7 |
| 2 | 5.8 | 0.76 | 4.4 |
| 3 | 6.3 | 0.65 | 4.1 |
| 4 | 6.8 | 0.57 | 3.9 |
| | | | 17.1 |
Dividend in year 5 = $6.8 x 1.04 = $7.1
Price at the end of 4th year = $7.1 / 0.15 – 0.04 = $64.5
Present Value = $64.5 x 0.57 = $36.8
Price per share = $17.1 + $36.8 = $53.9
End of solution
The purpose of this article is to acquaint a student or common investor with somewhat understanding of the complexities of the calculations of the value per share. It is intended to enable them comprehend the basic concepts involved in the investments in stock and its valuation.
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