D’Shaun Jackson, an individual do-it-yourself investor, is reviewing retail companies for potential addition to his portfolio. The first company he considers is Discount Days Ltd. (DDL) an up-and-coming regional competitor in the dollar store segment. Jackson’s analysis shows that the company is profitable and has strong positive operating cash flows. While the company is working to expand the number of stores in its network, investing cash flows are exceeding operating cash flows. To date, the company has not paid dividends, but Jackson believes it will likely start once it has finished its expansion plans. Jackson decides to use a dividend discount model to value the shares and estimates that DDL will start paying an annual dividend of $0.50 per share at the end of year 4 with a modest growth rate of 2% per year. He uses the capital asset pricing model to estimate a cost of equity of 7.25%.
Q. Based on Jackson’s estimates and his selected model for DDL, the current share price is closest to:
- $7.20.
- $7.72.
- $8.17.
Solution
Solution
B is correct. The share can be valued using a two-stage DDM model with no dividends in the first stage, as follows:
– Calculate the terminal value of the stock using the Gordon growth model
– P0=D1(r−g), where D1 = $0.50, r = 7.25% and g = 2%
– That yields the present value at the start of year 4; the first dividend is expected at the end of year 4, thus D4 = $0.50 and value is at end the of year 3 (beginning of year 4)
– P3=0.500.0725−0.020=$9.52
– Discount that value for 3 years at 7.25% = $9.52/(1.0725)3 = $7.72
why they are taking D1 = 0.5 instead of 0.5(1.02) = .51
Co has not paid dividend yet. It will start paying dividend from 4th year onwards. That’s why D1=0.5.