Introduction. Statistically, it is represented as, V o = D 1. ( E r -g) Where, D 1 = Next Year Dividend Per Share

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1 Table of Contents Introduction... 2 Analysis... 3 Use of a constant growth rate... 5 Expected return on Equity and analysis thereof... 5 Criticism of Gordon s Model and alternatives to it... 8 References... 11

2 Introduction Investment in stock markets is a blend of appetite for risk and reward. One would be induced to invest in stock markets only if he foresees a positive reward for the same. Reward of investing in stock markets is the dividend earned, and it depends upon the profit made by the organisation. (Taillard,2012) Thus, analysis of where and when to invest involves analysis of dividend so as to understand fairly the possible results of investment and to decide whether to invest or not? To make this tedious and confusing task simple have been established several models that facilitate analysis of dividend and thus the analysis of stock. This enables investment decision making to a greater extent. One of the most credible and used method of dividend valuation is the Gordan s Dividend Growth Model also known as Gordon Constant Growth Dividend Valuation Model and is based upon the work of Myron. J.Gardon in This model helps in determining the intrinsic value of a stock, exclusive of the persisting market condition and it assumes that dividends shall grow at a fixed/constant rate till perpetuity. (Higgins, 2008) Statistically, it is represented as, Where, V o = D 1 D 1 = Next Year Dividend Per Share ( E r -g) E r = Investor s discount rate or Required rate of return g = The Expected Dividend Growth Rate

3 Analysis For, the purpose of our better understanding and practical analysis of the Gordon Model, we have taken real historical data s from DATANALYSIS for dividend paid by 4 major companies operating in different industries listed on the Australian stock exchange over the period of 10 years spanning from (01/07/ /06/2014). The industries chosen for this purpose are, 1. National Australia Bank Limited (NAB):- National Australia Bank Limited is one of the major players of the Banking industry in Australia.It is listed on Australian stock exchange since 1962 and is currently trading with a market capitalization of $81,365 Million comprising of 2,353.8 million shares. The company is majorly engaged in banking services, credit and access card facilities, leasing, housing and general finance, international banking, investment banking, wealth management, funds management, life insurance and custodian, trustee and nominee services. 2. Ansell Limited (ANN):- Ansell Limited is one of the leading healthcare equipment & Supplies Company in Australia. It is listed on the exchange since Today it boasts of a market capitalization of $2,785 million. The company is engaged in developing, manufacturing & sourcing, distribution and sale of gloves and protective products in the industrial and medical gloves market, as well as the sexual health and well being category. 3. BHP Billiton Limited (BHP):- BHP Billiton is one of the major mining industry participants in Australia. It is listed on the exchange since It is one of the oldest. It has a market capitalization of $119,740 million and a share base of 3,211.8 million shares. The company is engaged in exploration of natural resources like potash, coal etc. and development of mines with a purview towards assisting in sustainable development of the nation while not compromising with the demand of present. 4. Coca Cola Amatil Limited (CCL):- Coca Cola Amatil Limited is the leading player in the FMCG category in Australia it deals in food and beverage industry and is nominated as being one of the most popular FMCG players in the country. With a market capitalization of 6.93 billion. This organization has strong fundamentals to drive the market demand in its own direction.

4 For the purpose of our analysis of the dividend for a period of 10 years for all of the aforementioned companies, there data s have been tabulated into the following spreadsheet and the data for the companies appear in the individual spreadsheet s bearing the name of the companies. Microsoft Office Excel Worksheet Dividend is the distribution of company s earning declared by the management for its common shareholders. Dividend is of various types and it has been experienced that almost all of the companies have declared the following types of dividend, 1. Interim Dividend: These are the dividend that is declared by the organization prior to its AGM and prior to the declaration of its year-end financial results. Companies with good financial performance may choose to reward its shareholders with this kind of interim dividend on a quarterly or semi-annual basis. Howsoever it must be noted that an interim dividend is never an obligation on the company. (Tija, 2009) 2. Final Dividend: Final dividend is the dividend declared for the shareholders class after the closing of financial year and usually at the AGM. These are the rewards out of the yearly performance of the organisation, and are usually a determinant of performance for the masses and other stakeholders. 3. Special Dividend: Some companies like in our analysis Coca Cola Amatil limited had declared a special cash dividend in lieu of its good performance. However this type of dividend is not taken into account while determining the year- end dividend income. The dividend and its equivalent computations may be found in the workbook below, Microsoft Office Excel Worksheet

5 Use of a constant growth rate Gordon Model assumes the dividends to grow in perpetuity at a constant growth rate provided the organisation is in a stable state. The model is a simple and powerful tool to valuate equity and it works on an assumption that the rate at which the dividends would grow would be constant and stable. Now this appears true in theoretical approach but practically it is more of an assumption because the market behaviour towards a particular stock can never be constant and thus the intrinsic value generated by the Gordon model may hence give misleading results. The annualised constant growth rate may be derived by the formula, Dividend current year = Dividend Base year * (1+g) ^ (n-1) This has been computed for all the 4 companies under consideration and may be observed in the below mentioned excel workbook against individual companies worksheet s. Microsoft Office Excel Worksheet Expected return on Equity and analysis thereof As analysed from the formula of the Gordon model, V o = D 1 ( E r -g) The key variables in the formulae are: D 1 i.e. the annual dividend for the next year and is derived by the formulae D 1 = D 0 ( 1+g) Where, D 0 is the dividend for the current year.

6 g is the growth rate at which dividends are assumed to grow till perpetuity. And, the most important of it being E r /K e or the Expected return on Equity: Expected return from equity is that minimum return that a shareholder expects to be generated from the equity share of a company. It is the rate of return that could have been generated if the same money would have been invested somewhere else and at equal risk. It holds immense value in investment decision making from the view point of rationale investor. (Brigham and Houstan, 2007) The expected return for each of the 4 company s dividend as has been derived as follows, Ansell Limited % BHP Billion Limited 10.31% National Australia Bank Limited 22.21% Coca Cola Amatil Limited 20.24% Please find the same in the workbook attached below, Microsoft Office Excel Worksheet

7 The Expected return as par our computations for each of the business have shown some significant results, 1. Ansell Limited: Ansell limited is a leading name in the healthcare industry in Australia. The healthcare industry s stocks have observed in the recent past a very good accord on the exchange. The buying rally in these stocks in the recent past has helped Ansell experience a rise in the stock prices over the period of time. Ansell has been declaring dividends at an almost constant rate over the year and its E r at 6.71% appears to be justified because seeing the positive stimulus in the market the shareholders do have a right to demand more incentive for their risk appetite. 2. BHP Billiton Limited: The return that shareholders expect from BHP Billiton s stock is observed to be 10.31%. This return is quite seeing the fall in the dividend growth rate of BHP Billiton in the past years as well as fall in the revenues quarter on quarter and year on year. BHP s stocks have been holding around a support range but seeing the negative movements in the mining industry the risk of holding such industry s portfolio is definitely high and so is the expected return on equity of BHP Billiton s stock. 3. National Australia Bank Limited: National Australia bank limited is a major banking industry player in Australia. In the past times banking industry in Australia has been on a stable state but in the recent past there seems to be turmoil in this industry and so is observed constant shortening of position by investors in this industry. National Australia Bank Limited dividend repayment trend has also been on the lower side and this is another reason for fall in the demand for its shares. This is a very possible reason for the high expected return from its stock. 4. Coca Cola Amatil Limited : Coca Cola is the king pin in the food and beverage /FMCG sector in Australia. Howsoever, this company has been observing a downward trend in its stock prices since March,2013. The dividend payout rate has dropped significantly and so is the demand for its shares. The expected return from its shares is computed to be 20.24%. This is possibly due to negative impressions about this stock and thus investors would look for a higher reward for taking risk of investment in its stocks.

8 Criticism of Gordon s Model and alternatives to it This model is criticized in following manner: The future growth pattern is impossible to predict because it will be inconsistent and uneven and dividend growth model estimates constant growth. Due to uncertainty of future and imperfect information, only historic growth is to be used for prediction of future growth. (Simon,2008) Calculating only cost of equity ignoring the cost of other forms of capital in not valid. Strength of Method The method is simple and clear calculation. The method shows the relationship between the value, growth, required rate of return and payout ratio. Help in valuing the growth of the dividend paid out by company. Alternative Methods 1. Dividend Yield Method According to this approach the cost of equity capital is the dividend per share as dividend by market price per share per share. The approach co- relates the basic factor of return and investment from the point of view of the investor. Ke represents the cost of equity.it is formulated as Ke = Dividend per share Market price per share Or Ke = Dividend per share Net Proceeds

9 This approach pre- suppose that an investor look forward only to dividends as a return on his investment. This method does not take into consideration that increases in dividend. It ignores that an investor also looks forward to capital appreciation in the value of his share. This company under this approach declares a higher amount of dividend out of a given quantum of earnings will be placed at a premium as compared to a company which earns the same amount of profit but utilize a major part of same in financing its expansion programs. (Krause,2009) 2. Capital Asset Pricing Method Every equity share has a distinct degree of risk. The concept of higher the risk, higher the expectation of return is followed in Capital Asset Pricing Method technique of measuring cost of equity. The logic of computation of cost of equity through this method is that investors expect more of return than Risk Free Rate for compensating them for taking risk. (Higgins,2008) The amount of premium depends upon the riskiness of the security. The Capital Asset Pricing Method bifurcates the cost of equity into two components, namely Risk free Return and Risk Premium of investing in particular share. The Market Risk premium is the difference between the market return and the risk free rate of return. The formula is stated as, Ke= R f + β (ER (m) R f ) Ke = Cost of equity R f =Risk free Rate of Return ER (m) = Expected Return of market β = Systematic Risk or sensitivity of Company (ER (m) R f )= Market Risk Premium This approach predicts the relationship between the risk and the expected return of risky assets. It provide a useful decision making framework for investors, by providing a measure for risk that can be quantified and operational by them. It represents the risk which cannot be eliminated by diversification. Therefore, contribution of single security to risk of a large diversified market portfolio depends only upon its systematic risk as measured by beta. Hence it can be said that the risk premium of equity is proportional to its beta that is, risk premium increase as beta increase and vice versa. This approach depends on the efficient investment market. It ignores the transaction cost. The assumption is that a well diversified portfolio is subject to systematic risk

10 alone is also questionable. A large investment in a company facing corporate collapse can well put a dent on a well diversified portfolio also. It is hard to accept that only market risk matters because specific risk can be diversified. Approach to be followed In case of company having stable income and with constant dividend policies the dividend pricing approach may be good way to measure the cost of ordinary share capital. In case of growth companies where expectation of growth rate is more important, the cost of equity share capital is to be measured by Gordon s Model. While the Capital Asset Pricing Method is taken for measurement where the risk is high and the expectation of return is also high. The basic factor of determining the cost of equity is to measure the expectation of investors from the ordinary shares of that particular company. Therefore, the whole matter is for determining the cost of share depends on the factor which goes into the expectation of particular group of investor in a company of a particular risk class.

11 References; 1. Simon, B 2008, Financial Modeling, MIT Press 2. Krause, A 2009, an overview of asset pricing models. University of bath, school of management. 3. Brigham & Houston 2007, Fundamentals of Financial Management. 5 th edition Thomson South-western. 4. Higgins, R 2008, Analysis for Financial Management. 9 th edition, Mc Graw Hill.Irwin 5. Ittelson, T.R 2009, Financial Statements: A step by step guide to understanding of financial statements.carrer Pr Inc 6. Tija, J 2009, Building Financial Models. 2 nd edition, Mc-Graw Hill 7. Taillard, M 2012, Corporate Finance for Dummies. For Dummies

FINANCIAL MANAGEMENT (PART-19) DIVIDEND POLICY I. Dear students, Welcome to the lecture series on Financial Management.

FINANCIAL MANAGEMENT (PART-19) DIVIDEND POLICY I 1. INTRODUCTION Dear students, Welcome to the lecture series on Financial Management. Learning Objectives Introduction Types of Dividend Policy Major issues