Estimating the market value of a share
The dividend expansion model suggests a method whereby share values can be estimated from information on the required return on equity and the expected dividend payable. The theory proposes that the value of a share is equivalent to the discounted value of the future dividend stream where the discount rate is determined by the return required by the investor. For instance if I decide that an investment is very risky the result may be that I require a return of 20% and the dividend flows will be discounted at this rate. In this manner the price that an investor places on a share is a reflection of his perceived risk re that investment together with his dividend expectations.
Using Crazy Games plc as an instance the formula for share valuation under the dividend growth model is as follows
Market value of share = D1/(R - G)
Where D1 = Next year's dividend
R = Investor's required return on the equity
G = Growth rate of the dividends
As of the figures given relating to Crazy Games plc
G = 16.36%
that is 4 √5.5 / 3 -1
R = 20%
D1 = 5.5 (1.1636) = 6.40 cents
Market value =6.40/0.2 0.1636
Market value = 175.8 cents
This denotes that to buy 1000 shares in Crazy Games would cost $1758.
It is significant to note that the model bases share prices on dividend growth rates even though, as in this case there is often a significant difference between the rate of growth of dividends and that of earnings.