ABDULLAH QAYYUM

ASSIGNMENT NO # 4

L1F17BSAF0060

SUBMITTED TO: SIR ABID NOOR

 Dividend Valuation
The Dividend Valuation model is a method of valuing stock shares based fundamentals, that
is, based on facts and expectations about a company's business, future cash flows and likely
risks. Dividend valuation uses a formula to construct the fair value of a company's stock based
on its dividend yield. The process of using known factors to determine a price is called
"discounting," and dividend valuation is often called the dividend discount model. The
purpose as with any valuation method is to determine which stocks are cheap, and should be
bought, which are expensive, and should be sold, and which are fairly valued and can be held.

Formula

Example
 Dividend Theories
The dividend valuation theories are as follows:
1. Relevance Theory:

According to relevance theory dividend decisions affects value of firm, thus it is called
relevance theory.
• Walter’s Model
• Gordon’s Model

2. Irrelevance Theory:

According to relevance theory dividend decisions do not affect value of firm, this it is
called irrelevance theory.
• Residual theory
• Miller & Modigliani Hypothesis (MM Approach)

Residual
Theory
 1. RELEVANCE THEORY:

GORDON’S MODEL:

This model examines the cause of dividend growth. Assuming that a company makes
neither a dramatic trading breakthrough (which would unexpectedly boost growth) nor
suffers from a dreadful error or misfortune (which would unexpectedly harm growth),
then growth arises from doing more of the same, such as expanding from four factories to
five by investing in more non-current assets. Apart from raising more outside capital,
expansion can only happen if some earnings are retained. If all earnings were distributed
as dividend the company has no additional capital to invest, can acquire no more assets
and cannot make higher profits.

It can be relatively easily shown that both earnings growth and dividend growth is given
by:

g = bR

Where b is the proportion of earnings retained and R is the rate that profits are earned on
new investment. Therefore, (1 – b) will be the proportion of earnings paid as a dividend.
Note that the higher b is, the higher is the growth rate: more earnings retained allow more
investment to that will then produce higher profits and allow higher dividends.

Formula
 Example

Assumptions of Gordon’s Model

Gordon’s model is based on the following assumptions.

1. The firm is an all Equity firm
2. No external financing is available
3. The internal rate of return (r) of the firm is constant.
4. The appropriate discount rate (K) of the firm remains constant.
5. The firm and its stream of earnings are perpetual
6. The corporate taxes do not exist.

7. The retention ratio (b), once decided upon, is constant. Thus, the growth rate (g) =
br is constant forever.

8. K > br = g if this condition is not fulfilled, we cannot get a meaningful value for
the share

Criticism of Gordon’s Model

Gordon’s theory on dividend policy is criticized mainly for the unrealistic assumptions
made in the model.
CONSTANT INTERNAL RATE OF RETURN AND COST OF CAPITAL
The model is inaccurate in assuming that r and k always remain constant. A constant r
means that the wealth of the shareholders is not optimized. A constant k means the
business risks are not accounted for while valuing the firm.
NO EXTERNAL FINANCING
Gordon’s belief of all investments being financed by retained earnings is faulty. This
reflects sub-optimum investment and dividend policies.
 WALTER’S MODEL:

According to the Walter’s Model, given by Prof. James E. Walter, the dividends are
relevant and have a bearing on the firm’s share prices. Also, the investment policy cannot
be separated from the dividend policy since both are interlinked.

Walter’s Model shows the clear relationship between the return on investments or
internal rate of return (r) and the cost of capital (K). The choice of an appropriate
dividend policy affects the overall value of the firm. The efficiency of dividend policy
can be shown through a relationship between returns and the cost.

➢ If r>K, the firm should retain the earnings because it possesses better investment
opportunities and can gain more than what the shareholder can by re-investing. The firms
with more returns than a cost are called the “Growth firms” and have a zero payout ratio.
➢ If r<K, the firm should pay all its earnings to the shareholders in the form of dividends,
because they have better investment opportunities than a firm. Here the payout ratio is
100%.
➢ If r=K, the firm’s dividend policy has no effect on the firm’s value. Here the firm is
indifferent towards how much is to be retained and how much is to be distributed among
the shareholders. The payout ratio can vary from zero to 100%.

Assumptions of Walter’s Model:

➢ All the financing is done through the retained earnings; no external financing is used.
➢ The rate of return (r) and the cost of capital (K) remain constant irrespective of any
changes in the investments.
➢ All the earnings are either retained or distributed completely among the shareholders.
➢ The earnings per share (EPS) and Dividend per share (DPS) remain constant.
➢ The firm has a perpetual life.
 Criticism of Walter’s Model:

➢ It is assumed that the investment opportunities of the firm are financed through the
retained earnings and no external financing such as debt, or equity is used. In such a
case either the investment policy or the dividend policy or both will be below the
standards.
➢ The Walter’s Model is only applicable to all equity firms. Also, it is assumed that the
rate of return (r) is constant, but, however, it decreases with more investments.
➢ It is assumed that the cost of capital (K) remains constant, but, however, it is not
realistic since it ignores the business risk of the firm, that has a direct impact on the
firm’s value.

Note: Here, the cost of capital (K) = Cost of equity (Ke), because no external source
of financing is used.

2. IRRELEVANCE THEORY:

RESIDUAL THOERY:

A residual dividend is a dividend policy that companies use when calculating the
dividends to be paid to shareholders. Companies that use a residual dividend policy fund
capital expenditures with available earnings before paying dividends to shareholders.
This means the dollar amount of dividends paid to investors each year will vary.

Formula

Dividends = Net Income – (Target Equity Ratio x Total Capital Budget)

 Example

As an example, a clothing manufacturer maintains a list of capital expenditures that are

required in future years. In the current month, the firm needs $100,000 to upgrade
machinery and buy a new piece of equipment. The firm generates $140,000 in earnings
for the month and spends $100,000 on capital expenditures. The remaining income of
$40,000 is paid as a residual dividend to shareholders, which is $20,000 less than was
paid in each of the last three months. Shareholders might be disappointed when
management chooses to lower the dividend payment, and senior management must
explain the rationale behind the capital spending to justify the lower payment.

MILLER AND MODIGLIANI THEORY

According to Miller and Modigliani Hypothesis or MM Approach, dividend

policy has no effect on the price of the shares of the firm and believes that it is the
investment policy that increases the firm’s share value.

The investors are satisfied with the firm’s retained earnings as long as the returns are
more than the equity capitalization rate “Ke”. What is an equity capitalization rate?
The rate at which the earnings, dividends or cash flows are converted into equity or
value of the firm. If the returns are less than “Ke” then, the shareholders would like to
receive the earnings in the form of dividends.

Assumptions of Miller and Modigliani Hypothesis:

➢ There is a perfect capital market, i.e. investors are rational and have access to all the
information free of cost. There is no floatation or transaction costs, no investor are
large enough to influence the market price, and the securities are infinitely divisible.
➢ There are no taxes. Both the dividends and the capital gains are taxed at the similar
rate.
➢ It is assumed that a company follows a constant investment policy. This implies that
there is no change in the business risk position and the rate of return on the
investments in new projects.
➢ There is no uncertainty about the future profits, all the investors are certain about
the future investments, dividends and the profits of the firm, as there is no risk
involved.
 Criticism of Miller and Modigliani Hypothesis:

➢ It is assumed that a perfect capital market exists, which implies no taxes, no flotation,
and the transaction costs are there, but, however, these are untenable in the real life
situations.
➢ The Floatation cost is incurred when the capital is raised from the market and thus
cannot be ignored since the underwriting commission, brokerage and other costs have
to be paid.
➢ The transaction cost is incurred when the investors sell their securities. It is believed
that in case no dividends are paid; the investors can sell their securities to realize
cash. But however, there is a cost involved in making the sale of securities, i.e. the
investors in the desire of current income has to sell a higher number of shares.
➢ There are taxes imposed on the dividend and the capital gains. However, the tax paid
on the dividend is high as compared to the tax paid on capital gains. The tax on
capital gains is a deferred tax, paid only when the shares are sold.
➢ The assumption of certain future profits is uncertain. The future is full of
uncertainties, and the dividend policy does get affected by the economic conditions.
➢ Thus, the MM Approach posits that the shareholders are indifferent between the
dividends and the capital gains, i.e., the increased value of capital assets.

Example:

Suppose a firm has 100000 shares outstanding and is planning to declare a dividend of $5 at the end of
current financial year. The present market price of the share is $100. The cost of equity capital, ke, may
be taken at 10%. The expected market price at the end of the year 1 may be found under two options:

➢ If dividend of $5 is paid

➢ If dividend is not paid

When Dividend of $5 is paid (the value of D1 is 5) :

P0 = (D1 + P1)/ (1+ ke)

P0 (1+ ke) = D1 + P1
P1 = P0 (1+ ke) – D1
= 100(1.10) – 5
= 105
So, the market price is expected to be $105, if the firm pays dividend of $5
When, Dividend of $5 is not pain (the value of D1 is 0):
P0 = (D1 + P1)/ (1+ ke)
P0 (1+ ke) = D1 + P1
P1 = P0 (1+ ke) – D1
= 100(1.1)
= 110
So, the market price of the share is expected to be $110, if the firm does not pay any dividend.
However, in both the cases, the position of the shareholders would be the same. A shareholder having for
example 1 share will be having same worth of his holding if the firm pays dividend or not. In case, the
dividend of $5 is paid, he will receive $5 from the firm as dividend and the market price of the share
would be $105, giving a total worth of $110. In case, the dividend is not paid then the market price of the
share or the worth of the shareholder would be still $110. So, the shareholder would be indifferent if
dividend is paid or not to him. The same example can be extended further to analyze the effect of
arbitrage employed by the firm.

The Most suitable theory of dividend valuation

The Gordon Growth Model is that it is the most commonly used model to calculate share
price and is therefore the easiest to understand. It values a company's stock without taking into
account market conditions, so it is easier to make comparisons across companies of different
sizes and in different industries.

Extremely simple
The Gordon growth model is extremely simple to explain and understand. It does not take too
much intelligence to assume that the dividends are expected go an increasing at a constant rate.
This simplicity is what makes this model widely understood and therefore widely used. More
complex models have been proposed in place of the Gordon model. But the Gordon model has
stood the test of time, because it mimics the dividend pattern exhibited by most companies and it
does so while maintaining its simplicity.

Find the correct intrinsic value of the share

Gordon growth model need not be applied only to find the correct intrinsic value of the share.
Instead, given the current share price, a reverse analysis can be conducted and the growth rate
being implied in the current market price can be found out. This helps in stating facts in a
manner which is intuitively understandable. For instance, if the result of this backward analysis
is that the dividends are expected to grow 20% year on year forever, then we know that this is
not possible and the firm is overvalued. When the whole economy grows at an average of 3% to
5% per annum, how can a single firm continue to grow at 20% forever?

Applicable to most companies

The Gordon growth model is applicable to most companies, especially if the company has a
relatively mature and stable business. Also, the Gordon growth model can be used to find out if
the indices are valued correctly or whether the market is amidst a bubble.
 Implication on a Company

Consider a company whose stock is trading at $110 per share. This company requires an 8%
minimum rate of return (r) and currently pays a $3 dividend per share (D1), which is expected to
increase by 5% annually (g).

The intrinsic value (P) of the stock is calculated as follows:

\begin{aligned} &\text{P} = \frac{ \$3 }{ .08 - .05 } = \$100 \\ \end{aligned}P=.08−.05$3=$100

According to the Gordon Growth Model, the shares are currently $10 overvalued in the market.