This requirement here was to calculate the equity market value of a company using the dividend growth model. The correct approach was to calculate the total dividend paid for each of two years, calculate the dividend growth implied by the two figures, and then use the dividend growth model (DGM) to calculate the equity market value.
Many candidates struggled to gain full marks on this question. Many candidates also wasted time working on a per share basis, dividing by the number of shares at the start of their calculations and then multiplying by the number of shares at the end of their calculations.
Many students were not able to calculate the dividends paid. Errors made here included applying the dividend payout ratio to the nominal value per share; using earnings instead of dividends; using the payout ratio as the dividend; making an error in the (unnecessary) calculation of the number of
ordinary shares; and taking the square root of the relative dividends (implying two years of dividend growth when only one year of growth occurred).
Even with the aid of the formulae sheet, many errors were made using the DGM, including using this year’s dividend as next year’s dividend; using earnings instead of dividends; using an integer form for the cost of equity but a decimal form for the dividend growth rate; subtracting the dividend growth rate instead of multiplying by it; and using the ‘cost of equity’ arrangement of the DGM, but claiming the cost of equity was the share price.
The key learning point here is the need for candidates to study the dividend growth model as a business valuation method, understanding the variables that are used by the model and avoiding unnecessary calculations on a per share basis when total figures can be used.
2(b) - The requirement here was to calculate the equity market value of a company using the earnings yield method. The correct approach was to divide the total earnings by the dividend yield of similar listed companies.
Both figures were provided and so the question requirement could be met by one calculation. Many candidates struggled to gain the two marks on offer.
There was no need to calculate earnings per share and there was no need to calculate the earnings yield of the company being valued: candidates making these calculations wasted valuable time.
Some candidates made the mistake of multiplying earnings by the earnings yield, rather dividing by it. Some candidates offered no answer to this question.
A key learning point here is that any business valuation method in the syllabus could be examined, so candidates must be familiar with them all.
2(c) - Candidates were asked to discuss the relative merits of the dividend growth model (DGM) and the earnings yield method as a way of valuing a company.
A key phrase here is ‘relative merits’ and candidates’ answers were expected to compare the two methods, although many answers did not do so.
Most answers failed to gain high marks, or gained low marks or no marks, because they were descriptive or because they discussed the two methods separately.
Descriptive answers often stated the obvious: ‘the DGM uses dividends to value a company’; ‘the DGM includes the cost of equity’; ‘the DGM looks at dividend growth’; without taking these points any further through discussion.
Answers discussing the two methods separately might comment on the merits or demerits of one method, but not relate these points to the other method.
Better answers, addressing the question requirement, would make comparative points, for example contrasting dividends (cash) with earnings (profit) as bases for valuing a company.
A key learning point here is that candidates must develop the ability to critically discuss the techniques that they learn to apply, in order to understand why one technique might be preferred to another in a particular situation.