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Fundamentals: Growth Model

Growth model is one of the methods to calculate/gauge/determine the company’s fair value. There are two common growth model that is widely used;

  1. Dividend Discount Model (DDM) – or also known as the Gordon Growth Model is used to calculate the intrinsic value/fair value of a stock based on an expected series of dividends that grow at a constant rate.

P = Price of stock

D1 = Expected Dividends for the next period

r = required rate of return

g = dividend growth rate

Example: Company ABC Bhd’s share price is currently trading at RM1.20 with a share issue of 100 million shares. ABC Bhd has a dividend policy of minimum 15% pay-out from its net profit per annum. Assuming, ABC Bhd generated a net profit of RM100 million over the next year, the company is bound to allocate RM15 million (15% x RM100 million) as dividends to its shareholders. Hence, the expected dividend per share would be;

 

Expected Dividend (D1) = RM15 million / 100 million shares

= RM0.15 per share

Assuming the investor’s required rate of return is at 15% and the dividend growth rate is at 5%.

P = RM0.15 / (15%-5%)

= RM1.50

With current share price trading at RM1.20 and the intrinsic value from DDM is at RM1.50, Company ABC Bhd’s share price offers a 25% [(RM1.50-RM1.20)/RM1.20 x 100%] upside.

 

However, one of the short-coming of the aforementioned model is that the assumption of a constant dividend growth rate in perpetuity. This assumption is generally more applicable for mature companies with stable dividend pay-out, whilst companies at the stage of growth would present fluctuating dividend growth rates in the early years.

  1. Capital Asset Pricing Model (CAPM) – is used to calculate the return on investment of a particular asset for a degree of risk undertaken.

 

Ra = Expected return of asset

Rf = Risk-free rate

βa = Beta of asset

Rm = Market risk

 

Example: The risk free rate (10-year Malaysia government bond yield is at 4.2% and assuming the beta (correlation between the volatility of the stock’s price vis-à-vis market volatility) of company ABC Bhd is at 0.6 while the market risk is at 15%.

Market risk premium = βa (Rm-Rf)

= 0.6 (15%-4.2%)

= 6.5%

Ra = Rf + βa (Rm-Rf)

= 4.2% + 0.6 (15%-4.2%)

= 10.7%

As a result, investors must be prepared to undertake a risk premium of 6.5% in ABC Bhd for a potential upside of 10.7%.

 

With this information, it enables you to calculate the risk that will be faced as well as the fair value of the company before going into any investments. Therefore, it is essential to understand the fundamentals of a company prior to your investments. Fundamentals would provide you with the background of a company as well as its stability. Apart from growth model, other aspects should also be reviewed. In M+ Online we provide the Insage Fundemental Analysis system for free at your disposal. Log on to our trading page and try the feature today!

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