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14.15 Capital Gains (85/43) -- Introduction to Financial Analysis

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14.15 Capital Gains

14.15 Capital Gains It is interesting to note that, if G > 0, the model will automatically generate capital gains. Here again is our formula. Below is a problem whose resolution illustrates the model’s automatic generation of capital gains. Question: Formula: P0 = [D0 (1 + G)] / (R – G) P0 = D1 / (R – G) Given: D0 = $1 The Last Dividend R = 10% The Discount Rate G = 5% The Dividend’s Constant Growth Rate What is the price today? What would the price be in one year? Solution: P0= $1 (1 + .05) / (.10 – .05) = 1.05 / .05 = $21 Price in One-Year: P1 = D2 / (R – G) P1 = $1.05 (1 + .05) / (.10 – .05) = 1.1025 / .05 = $22.05 We observe that $22.05 / $21 = 1.05. That is to say that next year’s price will be greater than last year’s by 5%, or the same as the stock’s growth rate (again, assuming a constant pay-out ratio). We often say that a stock is “ahead of itself,” if the rate of growth in price exceeds the dividend – or earnings – growth rate (assuming a constant pay-out ratio). Capital Gains, Dividend Growth: Some Practice Problems The following should help summarize some relevant concepts. 1. Complete the empty cells, given the data noted below for a stock. The basic formula for the Dividend Discount Model is: P0 = [(D0) (1 + G)] ÷ [R – G] 2. Once again, complete the spreadsheet, given the data noted for a particular stock. Given: Solve: - Explain, in words, what is meant by the term, “G,” in question #2. - Assuming G is a constant (question #1), P0 (1 + G) = P1. Capital Gains, Dividend Growth: Some Practice Problems (Solutions) Problem 1: Problem 2:
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