# Stock Valuation Methods-Cases finance By Jim DeMello

Questions:

1.- How should Jonathan describe the rationale of the dividend discount model (DDM)

and demonstrate its use in calculating the justifiable price of common stock?

2.- Being a researcher, Dwayne asked Jonathan a key question, "How did you

estimate the growth rates used in applying the model?" Using the data giving in Tables 1

and 2 explain how Jonathan should respond.

3.- what is the rationale of the required rate of return that Jonathan used and how did he estimate it?

4.- "What other variations of the DDM can one use and Why?" asked Dwayne. What

should Jonathan respond be?

5.- " Why are you using dividends and not earning per share, Jonathan?" asked

Dwayne. What do you think Jonathan would have said?

6.- Dwayne wondered whether pharmcopia's preferred stock would be a better

investment than its common stock, given that it was paying a dividend of $1.50

and trading a price of $15. He asked Jonathan to explain to him the various features

of preferred stock, how it differed from common stock and corporate bonds, and

the method that could be used for estimating its value.

(Please see attachment for background)

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#### Solution Preview

See attached excel file for complete solution

Questions:

1.- How should Jonathan describe the rationale of the dividend discount model (DDM)

and demonstrate its use in calculating the justifiable price of common stock?

The dividend discount model (DDM) states that the price of the stock is

Po= Div1/ (r-g) where Po= is the price of shares

Div1=Dividend next year, r= required rate of return, g=growth rate

This is based on the following :

Value of a share=( Dividend received at the end of year + Price of the share one year from now) discounted at required rate of return

Po=( Div1+P1)/(1+r)

But P1= (Div2+P2)/(1+r)

Therefore Po= Div1/(1+r)+Div2/(1+r)^2+(P2)/(1+r)^2

But P2=(Div3+P3)/(1+r)

Therefore Po= Div1/(1+r)+Div2/(1+r)^2+(Div3)/(1+r)^3+(P3)/(1+r)^3

and so on

Therefore

Po= Div1/(1+r)+Div2/(1+r)^2+(Div3)/(1+r)^3+(Div4)/(1+r)^4+------

If we assume constant rate of growth of dividends=g

If Div2=Div1(1+g)

Div3=Div2(1+g)=Div1(1+g)^2

and so on

The infinite series can be simplified as

Po= Div1/ (r-g)

Thus if discount rate= required rate of return and growth rate is known

The price of a share can be calculated

2.- Being a researcher, Dwayne asked Jonathan a key question, "How did you

estimate the growth rates used in applying the model?" Using the data giving in Tables 1

and 2 explain how Jonathan should respond.

Table 1

Year Sales Net ...

#### Solution Summary

The solution explains the dividend discount model, calculates share price using the dividend discount model , estimates g , the growth rate of dividends and compares preferred stock with common shares.

The solution consists of an attached Excel file that answers completely the 6 case questions.