Question

The past year dividend was INR 12 and the expected subsequent dividend growth is 5% per annum as per the analyst’s conference call with the management. The company is expected to pay these dividends in perpetuity. The current share price of a firm that you are tracking is INR 70 per share. You go back to basics and look at this firm’s returns over the past 5 years and using the monthly re- turns, you arrive at a beta of 2. The market return is 13.5 percent. The yield for the government security which is typically considered to be risk free is 6 percent. What do you think about this stock’s current price in the market? If you are expected to give a guidance based on the above information, what will be your recommendation on this stock? Next, if you receive new information that the overall risk aversion in the market has decreased by 250 bps owing to opening up of the market and the monetary policy committee is expected inflation to go up by 50 bps, what is the impact on the expected return, will you change your guidance now?

Answer 1

Dividend next year = 12 * (1+5%) = 12 * 1.05

= 12.6

Ke, as per CAPM;

Ke = Risk free rate + Beta (Market return - Risk free rate)

= 6% + 2 (13.5% - 6%)

= 6% + 2 * 7.5%

= 6% + 15%

= 21%

Now, value of the share = dividend/ke -g = 12.6/21% - 5%

= 12.6 / 16%

= 12.6 / 0.16

= 78.75

So, the vaue of the share is INR 78.75

The worth of the share is 78.75 and if someone is getting at 70 then one should go for it.

If inflation will go up by 5% then this will reduce the Ke and accordingly decision can be made.