Dividend Discount Model And Price Earnings Ratio Model Finance Essay

In the literature reappraisal, that is, the old chapter, surveies on the two rating theoretical accounts were scrutinised. In this chapter, the rating theoretical accounts viz. Dividend Discount Model ( DDM ) and the Price Net incomes Ratio theoretical account ( PER ) will be presented. The methodological analysis that will be used in the survey will be consistently presented from the derivation of the theoretical accounts to the computation of each variable that will be used. These theoretical accounts aim to calculate the intrinsic values of the companies that are listed on the ‘Banks & A ; Insurance ‘ sector of the Stock Exchange of Mauritius ( SEM ) viz. :

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Companies

Mauritius Commercial Bank

MCB

Mauritanian Eagle

Japanese apricot

Mauritius Leasing

MLC

Mauritius Union

MUA

State Bank of Mauritius

SBM

Swan Insurance

Swan

Table 1: Banks & A ; Insurance ( SEM )

As mentioned earlier, the chief purpose of this survey is to calculate the intrinsic values of the six companies listed supra. Thereafter, these intrinsic values will be compared to the several quoted market monetary values of the six companies of the Banks & A ; Insurance sector of the SEM. Theoretically, if the computed intrinsic values are greater than the quoted market monetary values, this will connote that the portion value is underpriced. Otherwise, if the quoted market monetary values are greater than the computed intrinsic values, therefore connoting that the portion value of the companies is overpriced. In the terminal this analysis will assist to determine whether portions are being right valued or non. Furthermore, this information will turn out to be utile for the stakeholders of the company as it may foretell market monetary values and even find whether market monetary values give a just position of the companies ‘ public presentation. Existing and even possible stockholders will desire to cognize whether they are purchasing or selling the portions at the right monetary value. This analysis may turn out to be utile to the companies in their strategic planning and determination devising.

Dividend Discount Model

Changeless Growth Dividend Discount Model

The dividend price reduction theoretical account ( DDM ) is used for finding the value of a common stock with a changeless growing rate for the dividends. In other words, dividend payments are expected to turn at a changeless rate forever. We can show all the future dividends in footings of the approaching dividend ( D0 ) as follow:

Therefore the undermentioned equations will be obtained.

The advantage of making so is that the expression for the common stock ‘s intrinsic value can be simplified as follows:

The DDM represented by the expression above ( i.e. changeless growing rate ) is known as the changeless growing DDM or the Gordon growing theoretical account.

Appraisal of the Annual Dividend Growth rate ( g )

There are a few things that must be taken into consideration before utilizing the changeless growing DDM to gauge the value of a common stock. The theoretical account is merely suited for stocks that have a growing rate that is lower than the needed return. In order to gauge the growing rate in dividend the historical dividends will be used. Using the point-to-point appraisal method, which is based on the first and last dividend of the growing period, the growing rate of the dividend during that period will be estimated as follows:

Actual Dividends paid by MCB

Year

2005

2006

2007

2008

2009

2010

DPS ( Rs )

1.9

2.12

2.9

4.55

5.25

5.25

Beginning: MCB Annual Reports

Actual Dividends paid by MEI

Year

2005

2006

2007

2008

2009

2010

DPS ( Rs )

4.75

4.75

0.75

1.83

1.83

1

Beginning: MEI Annual Reports

Actual Dividends paid by MLC

Year

2005

2006

2007

2008

2009

2010

DPS ( Rs )

0.01

0.01

0.02

0.04

0.03

0.03

Beginning: MLC Annual Reports

Actual Dividends paid by MUA

Year

2005

2006

2007

2008

2009

2010

DPS ( Rs )

0.84

3.4

3.5

3.9

9.4

4.4

Beginning: MUA Annual Reports

Actual Dividends paid by SBM

Year

2005

2006

2007

2008

2009

2010

DPS ( Rs )

1.3

2

2.1

2.55

2.75

2.75

Beginning: SBM Annual Reports

Actual Dividends paid by SWAN

Year

2005

2006

2007

2008

2009

2010

DPS ( Rs )

5

5

5.5

6

7

7.7

Beginning: SWAN Annual Reports

Calculation of the Cost of Equity ( K )

In order to gauge the cost of equity ( K ) the Capital Asset Pricing Model ( CAPM ) will be used where

K = Rf + Bi ( Rm + Rf )

Where K is the expected cost of equity

Rf is the hazard free rate of return

Rm is return on equity on the market

Bi is the company ‘s systematic hazard.

Calculation of the hazard free rate of return ( Rf )

The leaden mean Treasury Bill rate for the Government of Mauritius with adulthood of 364 yearss is being used as a placeholder for the hazard free rate ( Rf ) . This hazard free rate will be estimated by taking the norm of all the leaden Treasury Bill rates from 2005 to 2010.

Leaden mean Treasury Bill rate ( 364 yearss )

Year

2005

2006

2007

2008

2009

2010

Leaden mean Treasury Bill rate

6.23

7.46

11.63

9.25

7.61

4.63

Beginning: Bank of Mauritius Annual Reports

Where ten is the amount of all the leaden mean Treasury Bill rate

N is the figure of old ages from 2005 to 2010.

Calculation of the return obtained on equity on the stock market ( Rm )

For the computation of the return on the market the Stock Exchange of Mauritius Total Return Index ( SEMTRI ) will be used. The chief aim of the SEMTRI is to supply investors an of import tool to mensurate the public presentation of the local market. The SEMTRI provides an indicant for capital gain/loss and gross dividends on the SEM. Using the SEMTRI Rm can be calculated as follows:

Where SEMTRI DEC 2010 is the shuting month terminal figure for SEMTRI at December 2010

SEMTRI DEC 2005 is the shuting month terminal figure for SEMTRI at December 2005

N is the figure of old ages from 2005 to 2010.

Calculation of the company ‘s systematic hazard ( Bi )

The betas of the companies will be calculated by taking the day-to-day returns in the market quoted portion monetary values and utilizing the day-to-day returns from the SEMDEX as the benchmark. The betas will be calculated utilizing EXCEL ( Please refer to Appendix.. ) . Hereunder is a table demoing the betas of the several companies.

A

Beta

R2

MCB

0.9805

0.8904

MUA

0.5731

0.2558

SBM

1.2447

0.8900

Swan

0.5847

0.4043

Two-Stage Dividend Discount Model

The changeless dividend growing theoretical account is merely suited for finding the value of stocks of an established company. The theoretical account will merely work when:

( 1 ) the growing rate is changeless and

( 2 ) the growing rate is less than the needed return.

The old theoretical account i.e. the changeless growing theoretical account can be modified and changed into a two-stage theoretical account. The first phase is considered the unnatural growing phase, where the company is sing a rapid growing. The 2nd phase is where the company matures and its growing rate has slowed. It is assumed that the company will prolong that lower growing rate indefinitely.

Abnormal growing phase

If the company goes through the unnatural growing phase for T periods. The present value of all the dividend payments in the unnatural growing phase can be calculated as follows:

Therefore, if, the dividend payments are approximated based on the estimated unnatural growing rate ( tabun ) the above expression will be as follows:

Constant ( or normal ) growing phase

In the normal growing phase, the dividends are assumed to turn at a changeless rate ( gn ) indefinitely. Therefore, we can utilize the changeless growing dividend price reduction theoretical account to gauge the value ( PVn ) of the stock in clip T.

Once once more, it frequently clip necessary to gauge the DT+1 based on the anterior dividend ( DT ) . But here the dividend will now be turning at the normal rate as this is the normal growing phase. The expression for the value of the stock in the changeless growing phase ( in clip T ) is as follows:

Now, to find the present value of the stock at clip 0 ( i.e. the current period ) :

Entire value of a two-stage growing stock

The value of a two-stage growing stock is merely the amount of its present value in the unnatural growing phase and the present value in the normal growing phase:

In the above theoretical account, it has been assumed that the needed return for the stock is the same for both the abnormal and changeless growing phases. However, investors are really likely to hold different returns for the two phases. Since company by and large faces more hazards during its unnatural growing phase, investors will necessitate a higher return during this phase. On the other manus, the company is maturating during the normal growing phase and therefore faces less hazard. As a consequence, investors are besides demanding a lower return during this phase.

Appraisal of the growing rates for the two different periods.

The growing rate for the two different periods will be calculated in the same mode as it was calculated antecedently for the Constant Growth Dividend Discount Model. However, the clip period which was antecedently 10 old ages for the Constant Growth Dividend Discount Model, will now be divided into two. The first 5 old ages will be the unnatural growing phase and later the staying 5 old ages will the normal growing phase. Hereunder a tabular array bespeaking the growing rates for the several companies and periods is presented.

A

2000-2004 ( tabun )

2005-2009 ( gn )

MCB

6 %

10 %

MUA

10 %

9 %

SBM

13 %

12 %

Swan

8 %

9 %

Calculation of the cost of equity ( K ) for Two Stage Dividend Discount Model

The same cost of equity that was used for the Constant Growth Dividend Discount Model will be used for the Two Stage Dividend Discount Model. In the current theoretical account the cost of equity is assumed to be the same for the two different periods.

Monetary value to Net incomes Ratio

Another attack to placing desirable stocks is the usage of the P/E ratios ( or price-earnings multiples ) , which is really common among many investors.

Unlike the dividend price reduction theoretical account, there is truly no distinct reply on what the size of a P/E ratio should be in order for a company to be considered as a good investing. It depends on the investor ‘s investing doctrine. Regardless of your investing doctrine, it is of import for you to understand how the P/E ratio of a company is determined and what are some of the factors that influence it.

Deducing the P/E Ratio

This is rather simple as the P/E ratio is obtained by spliting the monetary value per portion by net incomes per portion. However, in order to cognize what influences the P/E ratio, the changeless growing dividend price reduction theoretical account will be used. The expression for the original theoretical account is as follows:

The future dividend, D1 = ( 1-b ) E1, where B is the keeping rate and E1 is the net incomes per portion in clip 1, when integrated into the above theoretical account will be as follows:

By pull stringsing the expression and the undermentioned consequences will be obtained:

If there is no maintained net incomes ( i.e. B = 0 ) , hence, the company is non puting in any new undertakings and will non be turning ( i.e. g = 0 ) . Consequently, the P/E ratio of a no growing company is merely:

Mentioning to the old theoretical account, the undermentioned term of a company ‘s P/E ratio represents its growing potency:

Growth possible

For a mature company to turn, it has to hold a positive growing potency. Therefore, the undermentioned conditions must keep:

First the needed return must be greater than the growing rate. ( K & gt ; g )

And secondly, in order for a company to hold a positive growing potency, the company will hold to put in undertakings that generate returns ( ROE ) that is greater than the investors ‘ needed return. If ROE is less than k this implies that the return from the new undertakings is less than the investors ‘ needed rate of return. In such a state of affairs, it is better for the company to merely administer all the net incomes as dividend payments instead than retaining all or portion of it for new undertakings. ( g – kilobit & gt ; 0 i?z B ( ROE ) – kilobit & gt ; 0 i?z ROE & gt ; K )

Data beginnings and trying

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