Accounting Calculation of Dividend Valuation Model

Question: Discuss about the calculation of dividend valuation model, it can be concluded that current share price (116.55) of the companys is lower than the calculated share price (196.22) through use the dividend valuation method? Answer: Introduction British American Tobacco plc (BAT) is a British multinational tobacco company that is a leading company that successful worldwide. BAT is operating in more than 180 countries and has taken leading position in around 50 countries. BAT is one of the worlds five largest tobacco companies and it products are enjoyed by millions of consumers in the worldwide. BAT largest and most popular brands are Benson Hedges, Dunhill, Kent, Kool, Lucky Pall Mall, Strike, and Rothmans. The company act responsibly and with integrity. In the year 2012, BAT market capitalization of 65.6 billion that is the sixth-largest of any company those are listed in LSE (London Stock Exchange). It indicates the leading position of the company in the tobacco sector and in the international market. This paper evaluates the shape of the UK yield curve and explains the concept of the UK market risk premium under existing market conditions. In addition, this paper evaluates the price of the BATs share through using the D ividend Valuation Model and recommends the BATs share should be held, bought or sold at present time. Shape of the UK Yield Curve The Bank of England division of the Macro Financial Analysis estimates yield curves for the UK. The below chart indicates the government liability nominal yield curves are derived from UK gilt prices and General Collateral (GC) repo rates. The real yield curves are derived from UK index-linked bond prices. The instruments used in the construction of the commercial bank liability curve are first converted into synthetic bonds, and the same method is then used to produce the commercial bank liability curve as is used for the nominal UK government curve. The nominal OIS (overnight index swap rates) yield curves are derived from the fixed interest rate component of spot OIS contracts (Bank of England, 2015). In addition, the spreadsheets on the Bank of Englands website provide spot rates and instantaneous forward rates for each type of curve. In the below graph, for horizons out to five years, points on the curves are available at monthly intervals. Moreover, the below graph also show available points on the government and bank liability curves out to a horizon of 5 years at half-yearly intervals. Moreover, the yields on UK government based on bonds (gilts) and include nominal and real yield curves and the inflation term structure for the UK (Bank of England, 2015). The estimates of the UK government curve from the period of 2007 to December 2014 that is derived from the estimates of the nominal government liability curves. (Source: Bank of England, 2015) The above graph shown the normal yield curve and indicates that longer maturity bonds have higher yield compared to short-term bonds because long-time risk is higher than short-time. Many economics conceive that a vertical positive curve (normal yield curve) shows higher interest rates, so investors expect high upcoming inflation and strong upcoming growth of the economy (Baker Pow, 2009). The UK yield curve (Shown in below diagram), the short-term yield (blue line) is higher than long-term yield (pink line) that is the sign of coming recession in the future. Many economics consider that an aggressively inverted yield curve indicates low interest rates, so investors assume low inflation and slow economy in the future. In the UK yield curve (in below diagram), short-term and long-term yield are similar or close (not major differences in blue and pink lines) to each other and shown an economic transition situation. The treasury securities are plots the flat yield curve because it is generally considered risk-free. The shape of the yield curve changes over time as it is lower and increased according to time period. Moreover, less changes in the yield curve indicates less uncertainty and changes in inflation and economic growth (Shenkman, Weiner Taback, 2003). In addition, the yield curve shows the less risky position of the UK market or economy due to the improvement in the chat or upward trend of the curve. At the same time, the UK yield curve shape is upward that indicates the good or positive sigh of the economy and the good inflation term structure for the UK. It represents the positive sign for the future of the UK government and indicates the Bank of England will focus on monetary policy through decrease short-term and long-term interest rate to increase growth of economic and face inflation pressure. So, future inflation impacts on yield curve as it change in a vertical positive curve (normal yield curve in the above chart). It indicates the UK government and the Bank of England focused or contributed to maintain the growth of the country through monetary policy (Bank of England, 2015). Moreover, it indicates the good situation of the investors point of view due to upward trend of yield curve and improving trend of the UK economy. UK Market Risk Premium Market risk premium is a central component of every risk and return model in finance. The standard approach to assume market risk premium remains through the use of historical returns data with the difference in annual returns on stocks and bonds over a long time period containing the expected risk premium. The main limitation related to this approach in the UK is the required long periods of historical data and its complete failure in emerging markets as well as the limited and noisy trend of the historical data (Albrecht, Stice, Stice Swain, 2007). In this situation, the UK market risk premium can be estimated through using a base of equity premium and a country risk premium. The alternative approach to estimate market risk premium is based on the updated estimates for most markets without historical data. In addition, risk and return model estimate risk in terms of variance in actual return around an expected return as the investment is riskless if actual return is equal to the expected market return (Batten Szilagyi, 2011). The below graph indicates the equity risk premium historical data points of the UK that have been calculated after taking inflation into account and are based on annual returns. The below graph indicates the past ten year equity risk premium is trending downwards that means risky situation of the market. (Source: See It Market, 2015) In addition, the recent times, the mostly preferred model of estimate market risk through the use of the local currency sovereign rating from Moody's. The Moody's equivalent of the SP rating that estimate the default spread for that rating (based upon traded countries bonds) over a default free UK government bond rate. United Kingdom Moodys rating is Aa1 that indicates the medium risk situation of the market (Damodaran, 2015). Moody rating and the above graph indicates the risky situation (more than average risk premium) of the UK market. Using Dividend Valuation Model to Evaluate the Price of the BATs Share In this section, using the dividend pricing model to evaluate the price of the BATs share and use it to make a recommendation on whether the share as at 1 June 2015, should be held, bought or sold. The below table indicates the share price of British American Tobacco plc (BAT) in the last 25 years at the year ended 31 December: Year Share price 1990 3.5 1991 3.54 1992 4.52 1993 5.25 1994 4.92 1995 6.64 1996 6.25 1997 7.72 1998 8.85 1999 4.25 2000 7.57 2001 9.39 2002 10.9 2003 17.12 2004 22.16 2005 30.41 2006 42.05 2007 50.44 2008 40.79 2009 51.93 2010 60.62 2011 78.97 2012 92.76 2013 89.27 2014 109.46 (Source: Yahoo Finance, 2015) The chart of the changes in the BATs share price in the last 25 years shown in the below that shown the continuous upward trend and high growth of the prices of the share in the market. The below graph and the above table indicates the BATs share price declines highly in 2008 due to the global financial condition but it increased in 2009 and also achieved high growth after crisis. The below table and graph indicates the dividends given by the British American Tobacco plc (BAT) in the last 25 years: Year Dividend Paid 1990 1.040 1991 0.514 1992 0.600 1993 0.589 1994 0.798 1995 0.891 1996 0.995 1997 1.072 1998 0.796 1999 1.000 2000 0.917 2001 0.949 2002 1.071 2003 1.232 2004 1.414 2005 1.615 2006 1.799 2007 2.352 2008 2.648 2009 2.776 2010 3.233 2011 3.852 2012 4.222 2013 4.336 2014 4.904 Average 1.825 (Source: Yahoo Finance, 2015) On the basis of the above 25 years trends of the dividend paid by the BATs, it can be stated that the continuous improvement in the financial performance of the company. On the basis of the continuous growth and upward trend of the BATs share prices in the market and dividend given by the company indicates the investors would have earned sufficient return with less risk in the past 25years those invest in the company stock price (Baker Pow, 2009). Dividend Valuation Model: P= d0 (1+g)/k-g There, d0= Past year dividend (average of 25 years) = 1.825 g (risk free rate) = US 10-year Treasury Bond Rate = 2.14% (Yahoo Finance, 2015) K = Constant growth rate in perpetuity expected for the dividends= 3.09% (Yahoo Finance, 2015) Then, P= d0 (1+g)/k-g (Albrecht, Stice, Stice Swain, 2007) =1.825 (1+0.0214) / (0.0309-0.0214) =1.825 (1.0214)/0.0095 =196.22 Actual share price on 17 August was 116.55. Recommendation On the basis of the above calculation of dividend valuation model, it can be concluded that current share price (116.55) of the companys is lower than the calculated share price (196.22) through use the dividend valuation method. On the basis of the dividend valuation method calculation and current share price, it can be recommended that BATs share would not be purchase by the investors and they would sell the share of the company. The low value of current share price comparison of the calculated share price indicates the risks and less return situation from the investor point of the views. The dividend valuation method calculation indicates the investor would not earn high return if they invest in the BATs stock for the long-term time period. In addition, the past 25 years trends of the share price and dividend indicates differently from the dividend valuation methods as the future of the company is secured and it able to face any financial condition in the future. The continuous high growth and upward trends of the last 25 years regarding the share price and dividend paid to shareholders indicates the improvement in the companys financial performance and its ability to face any situation in the market. The past trends of the companys related to share price and dividend paid to investors growth indicates the different from the dividend value model that investment in the BATs share would be financial beneficial of the investors. The continuous growth trend and upwards situation indicates the less risky and high return situation or condition from the investors point of views. In addition, on the basis of the both the past trends and the dividend valuation method, it can be concluded or recommended that the investors would be invested or hold the BATs share due to the positive trends and strong financial position of the company. The high growth trends in the past 25 years of share price and dividend of BATs (upwards flow of both graphs in the above) indicates in the future the company would be also achieve growth, maintain financial performance and able to face any financial situation or uncertainty of the market. It represents the buy and hold decision of the BATs stock would be good financial decision of the investors points of views in regarding earn high return at less risks. So, the finally recommended that the investors should be held as well as bought the BATs stock to earn high return at less risks rather than invest in the other company. In the global market, the strong market share and strong financial position in the more than 50 countries also indicates the investment in the stock of the BADs would be better financial or economical decision of the investors. References Albrecht, W., Stice, J., Stice, E. Swain, M. (2007). Accounting: Concepts and Applications (10th ed.). USA: Cengage Learning. Baker, H.K. Pow, G. (2009). Understanding Financial Management: A Practical Guide. USA: John Wiley Sons. Bank of England. (2015). NOTES ON THE BANK OF ENGLAND UK YIELD CURVES. Retrieved from: https://www.bankofengland.co.uk/statistics/Documents/yieldcurve/yields_background_note.pdf Bank of England. (2015). Yield Curves. Retrieved from: https://www.bankofengland.co.uk/statistics/pages/yieldcurve/default.aspx Batten, J. Szilagyi, P.G. (2011). The Impact of the Global Financial Crisis on Emerging Financial Markets. UK: Emerald Group Publishing. Damodaran, A. (2015). Country Default Spreads and Risk Premiums. Retrieved from: https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html See It Market. (2015). Equity Risk Premium Historical Data: 1976 to 2012. Retrieved from: https://www.seeitmarket.com/equity-risk-premium-historical-data-1976-to-2012-13300/ Shenkman, M.M., Weiner, S. Taback, I. (2003). Starting a Limited Liability Company. USA: John Wiley Sons. Yahoo Finance. (2015). 10 Year Treasury Rate:2.14% for Aug 12 2015. Retrieved from: https://ycharts.com/indicators/10_year_treasury_rate Yahoo Finance. (2015). British American Tobacco p.l.c. (BTI). Retrieved from: https://finance.yahoo.com/q?s=BTIql=1 Yahoo Finance. (2015). British American Tobacco p.l.c. (BTI): Historical Price. Retrieved from: https://finance.yahoo.com/q/hp?s=BTIa=03b=14c=1990d=07e=17f=2015g=v