Introduction to Corporate Finance

5: Valuing Shares

expected to grow at 4% each year, forever. If we continue to use this dividend growth model, what would have
been the predicted price of Cochlear shares in December 2014?
Assume that the required rate of return on Cochlear shares is about 10%. Substituting into the constant
growth model – Equation 5.4 – the result suggests that Cochlear’s share price should be the following:

P = {[$2.54]/[0.10 – 0.04]} = $42

In fact, in mid-December 2014, Cochlear shares were trading for about $73. Although the growth model’s
estimate of Cochlear’s share price is below the company’s actual market value in 2014, it only takes small
adjustments in the model’s inputs to obtain an estimate that is much closer to Cochlear’s actual market value.
For example, if we lower the required return from 10% to 9% and increase the dividend growth rate from 4%
to 5.5%, the estimated value of Cochlear’s shares increases from $42 to $73.

The preceding example illustrates that, by making small adjustments to the required rate of return

or the dividend growth rate, we could easily obtain an estimate for Cochlear’s shares that matches the

actual market price. But we could also obtain a very different price with an equally reasonable set of

assumptions. For instance, increasing the required rate of return from 10% to 11% and decreasing the

dividend growth rate from 4% to 3% decreases the price all the way to $32. Obviously, analysts want to

estimate the inputs for Equation 5.4 as precisely as possible, but the amount of uncertainty inherent

in estimating required rates of return and growth rates makes obtaining precise valuations very difficult.

Nevertheless, the constant growth model provides a useful way to frame share-valuation problems,

highlighting the important inputs and, in some cases, providing price estimates that seem fairly

reasonable. But the model should not be applied blindly to all types of companies, especially not to those

enjoying rapid, albeit temporary, growth.

5-2e VARIABLE GRoWtH

The zero and constant growth ordinary share valuation models just presented do not allow for any change

in expected growth rates. Many companies go through periods of relatively rapid growth followed by a

period of more stable growth. Valuing the shares of such a company requires a variable growth model, one

in which the dividend growth rate can vary. Using our earlier notation, let D 0 equal the last or most recent

per-share dividend paid, g 1 equal the initial (rapid) growth rate of dividends, g 2 equal the subsequent

(constant) growth rate of dividends, and N equal the number of years in the initial growth period. We can

write the general equation for the variable growth model as follows:

Eq. 5.5

=

+

+

• 
  

+

+

• 
  

+

+

+

+

×

−













P Dg +^1

r

Dg

r

Dg

rr

D

rg

(1 )

(1 )

(1 )

(1 )

(1 )

(1 )

1

(1 )

N

NN

N

0

01

1

1

01

2

2

01

2

...

PV of dividends during initial

growth phase

PV of all dividends

beyond the initial

growth phase

As noted by the labels, the first part of the equation calculates the present value of the dividends

expected during the initial rapid-growth period. The last term, DN+1 ÷ (r – g 2 ), equals the value, as of the

end of the rapid-growth stage, of all dividends that arrive after year N. To calculate the present value of this

growing perpetuity, we must multiply the last term by 1 ÷ (1 + r)N.

variable growth model

Assumes that the dividend

growth rate will vary during

different periods of time,

when calculating the value of

a company’s shares

example

See the concept explained

step by step on the

CourseMate website.

SMARt

CONCEPTS