The dividend discount model is a well-known model for pricing equity shares using the time value of money concept whereby the current fair price of a share is evaluated as the present value of future expected dividends.
In a relatively simple version of this model, it is assumed that the annual growth rate of dividends is constant and the current fair price of a share is obtained as next period's dividend divided by the difference between the expected annual return on equity and the constant annual growth rate of dividends. When the current price of a share is already known (e.g. by looking up the publicly available market information on the share prices), the constant dividend growth model (also called Gordon's model) can be inverted derive the annual return expected by the equity- holders of a certain stock. This is a methodology sometimes used to estimate the cost of equity capital for a firm.You are required to apply Gordon's model in estimating the cost of equity capital of a firm using real data drawn from a financial database.
a) Choose three Australian listed companies (one each from three different sectors) that have been in business for at least the last ten years. Access Morningstar Datanalysis Premium. Download onto a spreadsheet the last ten years (01/07/06 to 30/06/16) of dividend payments history for each of your three chosen companies.
b) All interim dividends must be appropriately annualized before adding up with the year-end final dividends in order to determine the true dollar value of yearly dividends received by the shareholders. For companies that have paid interim dividends, assume that those dividends were paid at the end of the first half of the year and therefore earn six months of interest at a risk-free rate for the next half. The current Australian Government 10-year bonds rate is 1.92% p.a.
c) After determining the dollar dividends received by shareholders for each of the past ten years, compute and justify a proxy annual constant growth rate of dividends to be used in Gordon's model. Use your computed proxy annual constant growth rate to predict next year's dollar dividend value.
d) Go to www.yahoo.com.au/finance and look up the closing price of each of your three chosen stocks as on 30/06/2016. Use Gordon's model to solve for the expected return on equity for each of the stocks. Do these expected return figures appear justified given the nature of the business, the overall market conditions and the industrial sectors within which each of your chosen companies operate? Explain.
e) What do you feel are the most serious methodological problems associated with Gordon's model? Outline your argument and carry out a review of relevant financial academic literature and identify at least two alternative cost of equity estimation methods. Can these identified methods be better than Gordon's model? Argue your case. (Maximum 1300 words for part (e))