Valuing Shares: Dividend Discount Models

Part A – Valuing Shares
INTRODUCTION
Dividend discount model is based on a concept that a stock is worth the present
value of the future dividend payments which it is going to receive in the future.
The present value of dividends is derived by discounting the future dividends at
required rate of return of the investor. The value derived from the model is
considered as intrinsic value. (Damodaran A.2009)
a) As per the analyst who produced the report A, Millenium tutoring is not
expected to grow although it will be profitable in the future.
The type of model used to value such company should be Zero growth Dividend
discount model. Zero growth model assumes that dividends are going to be
same till perpetuity. (Fridson and Alvarez, 2011)
So, Intrinsic value = Div1/re
= 1.5/0.12
=12.5
Where, Div1 = Dividend next year
re = Required rate of return
b) As per the analyst who produced the report B, Millennium Tutoring is
expected to grow at a steady constant rate. It distributes 30% as dividends. The
constant growth model or more commonly known as Gordon growth model
assumes that dividends are going to grow at a constant rate in the future and
hence it can be used.
To derive the value as per Gordon growth model we need to calculate growth
Growth rate = Retention ratio*ROE of the company
=0.7*13%=9.1%
Where retention rate = 100-30= 70; ROE = 13%
As per Gordon model, Intrinsic value = Div1/re-g
=1.5*0.3*1.091/0.12-0.091
= 16.93
Where Div1 = Dividend next year
re = Required rate of return
g= growth rate

c) The analyst who produced the report C expects a high growth rate in the
initial 3 years, followed by a constant growth rate thereafter. The model which
can be used for valuing it is Multi stage Dividend Discount model. Multistage
model derives the intrinsic value but dividends are discounted based on different
growth rates. The analyst expects 50 percent growth rate for next year, 20% for
following 2 years and 9% thereafter.
As per multistage model Intrinsic value of a stock =
D0(1+g1)/(1+re) + D1(1+g2)/(1+re)2 + D2(1+g2)/(1+re)3+ D3(1+g3)/(re-g3)
Where, D0= Dividends declared last year
D1 = Dividends declared in 1st year
D2 = Dividends declared in 2nd year
D3 = Dividends declared in 3rd year
g1 = 50% (Higher growth rate)
g2 = 20% (Higher growth rate)
g3 = 9% (Constant growth rate)
re = Required rate of return
=(1.5*0.3*1.5)/1.12+(0.675*1.2)/1.122+ (0.81*1.2)/1.123+(0.972*1.09)/(0.12-
0.09)
= 37.25
d) The feature that differentiates the different analyst valuation is primarily the
growth rates assumed by the different analysts. The higher the growth rates
assumed by the analyst the greater it’s valuation. (Pinto and Henry, 2016)
The additional information required to gather information on analyst’s
projections are-
1) The historical trend of growth rates in profits
2) Whether the company is having projects in hand so that it can invest in future
at same required rate of return
3) Basis for calculating required rate of return

PART B: ESSAY
INTRODUCTION
Risk management has become an important tool for every organisation to thrive
in this dynamic world. Most of the financial decisions made by the organisations,
households, governments and especially financial institutions is focused on the
management of the risk. Risk as a matter of fact can classified into various
types. However the most common ones are systematic risk and unsystematic
risk. (Crouhy and Galai, 2014)
The consumer electronics industry has seen a rapid growth in the 21st century
with people becoming more tech savvy and the use of technology has increased
due to ease of life provided by the same. As per research report the consumer
electronics industry as on 2017 was worth 1,172 billion USD. The consumer
electronics industry covers a portfolio of products like televisions, refrigerators,
smartphones, washing machines, DVD players, hard disk drives and digital
cameras. The prominent global players in the market being Samsung, Sony,
GoPro, LG Electronics, Apple, General Electric, Huawei, Bose, Sennheiser, Nikon,
Canon.
TYPES OF RISK AND DIVERSIFICATION STRATEGY
Systematic risk
Systematic risk refers to the risk which the company is facing with regard to
external factors and which cannot be controlled by the firm. Systematic risk is
driven by the market and cannot be completely diversified, although it can be
reduced. (Jorion and GARP, 2010)
The different systematic risk around the consumer electronics company are
listed below –
Interest rate risk – Interest rate risk for the company is the risk which the
company faces if the interest rates rise and this leads to higher borrowing costs
for the company. Interest rate risk can also lead to higher cost of capital for the
company. The higher interest rate payments lead to higher debt for the company
as compared to equity. The debt to equity ratio falls which may lead to the
company to default. This can only arise if the consumer electronics industry is
levered based on variable interest rates.
 Risk diversification strategy – The company hedges its interest rate
risk by taking positions in interest rate options. Interest rate call options
involve paying a premium initially and getting paid if the interest rate rises
above the exercise rate.