Question
Dividend policy plays a significant role in determining the market value of equity shares. Discuss the concept of dividend-based share valuation and explain the major models used for valuing equity shares.
Answer :
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Skip in 10
Dividend policy plays a significant role in determining the market value of equity shares because dividends represent the return received by shareholders from their investment. A company earns profits and may either distribute a portion of these profits to shareholders as dividends or retain them for financing future growth. The decision regarding the proportion of profits to be distributed and retained is known as dividend policy. Dividend-based share valuation attempts to determine the intrinsic or theoretical value of an equity share on the basis of the present value of expected future dividends. The underlying assumption is that the value of a share is related to the cash flows that shareholders expect to receive from owning it. The dividend-based approach is based on the principle that an investor purchases an equity share because of the expected returns in the form of dividends and capital appreciation. Since future dividends are uncertain and are received over different periods, they are discounted to their present value using an appropriate required rate of return. Thus, the value of an equity share can generally be expressed as the present value of all expected future dividends. The basic dividend valuation model can be represented as: P₀ = D₁/(1 + Ke) + D₂/(1 + Ke)² + D₃/(1 + Ke)³ + … + Dₙ/(1 + Ke)ⁿ Where P₀ represents the current value of the share, D₁, D₂, etc. represent expected dividends in different periods, and Ke represents the required rate of return or cost of equity. If dividends are expected to continue indefinitely, the value of the share is calculated by discounting the entire stream of expected dividends to the present time. One of the most important dividend-based share valuation models is the Walter Model. Developed by James E. Walter, this model establishes a direct relationship between dividend policy and the market value of a company's shares. Walter argues that the dividend policy of a firm affects its value because retained earnings can be reinvested by the company. The return earned on retained earnings is compared with the shareholders' required rate of return. The Walter Model is expressed as: P = [D + (r/Ke)(E − D)] / Ke Where P is the market price per share, D is dividend per share, E is earnings per share, r is the rate
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