Constant Dividend Growth Model

Using the constant dividend growth model,

Table of Contents

Po = Do (1+g) = D1 where Po = stock price at time 0

r-g r-g Do = dividend (Current)

D1= dividend (next)

g = growth rate in dividends

r = the required return n the stock

note that g < r

For ABC,

Po = $1.50 (1+ 0.06) = $39.75

0.10 – 0.06

For WHY,

Po = $2.25 (1+ 0.07) = $48.15

0.12 – 0.07

For XYZ,

Po = $1.75 (1+ 0.06) = $37.1—27

0.11 – 0.06

Analysis

Using the constant dividend growth model, it is clear that both ABC, WHY and XYZ are undervalued. This is because while the current market of ABC, WHY and XYZ is given as $30, $35 and $27 per share respectively, the constant dividend growth model gives the prices of ABC, WHY and XYZ as $39.75, $48.15 and $37.1 respectively.

The constant growth model is appropriate for companies whose dividends are reliably expected to experience considerable growth at a given rate going forward (Kevin 2006). Hence the constant growth model is most appropriate for firms that are relatively established.
There are however some inherent limitations of the constant growth model. First, this model can only be used for companies that are relatively mature and registering growth rates that are low to moderate. Next, Damordaran (2002) notes that this model has been found to be largely sensitive to the growth rate inputs.

References

Damordaran, A. (2002). Investment valuation: tools and techniques for determining the value of any asset. John Wiley and Sons

Kevin, S. (2006). Security Analysis and Portfolio Management. PHI Learning Pvt. Ltd.,

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