Question

1、

1）Last year’s dividend was $1.58 per share. Suppose that this dividend is expected to increase by 4% per year, and that investors currently require an 7.5% per annum expected return to invest in the shares of banks with a similar risk to the Coca Cola Company. Use the dividend valuation model to value Coca Cola Company (KO) shares. (3 marks)
2）Do the shares look undervalued or overvalued by the market, compared to your valuation? Explain your reasoning. Please write down the date on which you have completed your analysis, as the market value of the shares will change over time. (2 marks)

Answer 1

Solution (1)

As per dividend discount model, the value of a share is calculated as below:

Value of share= Expected dividend per share/(Cost of equity-dividend growth rate)

As given in the question,

Expected dividend= Last dividend*(1+g) = $1.58*(1+4%) = $1.6432

Cost of equity= 0.075 or 7.5%

Growth rate= 0.04 or 4%

Therefore, value of share is calculated as below:-

Value per share= $1.6432/(0.075-0.04)= $46.95 per share

Solution (2):

The share price of Coca cola co. at the close of 30th oct 2019 was $53.94 per share. Based on valuation as per dividend discount model as calculated in part (a) above, the share is overvalued by approx. $7 per share (53.94-46.95).

The reason why the shares look overvalued when we compare market value of share with intrinsic value calculated by dividend valuation model is because dividend valuation model only takes into account the dividends and the growth in dividends to come up at worth of a share. This is appropriate when a company distributes all its earnings as dividends. However, a company's true valuation can be evaluated based on its total earnings and not just dividends. The growing businesses will always have a part of their earnings reinvested in the business which will keep increasing the value of capital investment in shares, hence the true value of share will not be reflected in the valuation solely based on dividends and dividend valuation models will render valuation lower than the true intrinsic value of a share.

Due to the above reason, valuation of coca cola stock based on dividend valuation model seem to be overvalued when calculated intrinsic value is compared with current market value.