14.15 Capital Gains

It is interesting to note that, if G > 0, the model will automatically generate capital gains. Here again is our formula. Below is a problem whose resolution illustrates the model’s automatic generation of capital gains. 

 

Question:

Formula:

P0 = [D0 (1 + G)] / (R – G)

P0 = D1 / (R – G)

 

Given:

 

D0 = $1                       The Last Dividend

R = 10%                      The Discount Rate

G = 5%                       The Dividend’s Constant Growth Rate

 

What is the price today?

What would the price be in one year?

 

 

Solution:

Price Today:

 

P0= $1 (1 + .05) / (.10 – .05)

= 1.05 / .05

= $21

 

Price in One-Year:

P    = D2 / (R – G)

P1     = $1.05 (1 + .05) / (.10 – .05)

= 1.1025 / .05

= $22.05

 

 

We observe that $22.05 / $21 = 1.05. That is to say that next year’s price will be greater than last year’s by 5%, or the same as the stock’s growth rate (again, assuming a constant pay-out ratio).

 

We often say that a stock is “ahead of itself,” if the rate of growth in price exceeds the dividend – or earnings – growth rate (assuming a constant pay-out ratio).

Capital Gains, Dividend Growth: Some Practice Problems

The following should help summarize some relevant concepts.

 

1.  Complete the empty cells, given the data noted below for a stock. The basic formula for the Dividend Discount Model is:

 

P0 = [(D0) (1 + G)] ÷ [R – G]

 

 

2.  Once again, complete the spreadsheet, given the data noted for a particular stock.

Given:

 

 

Solve: 

 

 

  • Explain, in words, what is meant by the term, “G,” in question #2.

 

  • Assuming G is a constant (question #1), P0 (1 + G) = P1.

 

Capital Gains, Dividend Growth: Some Practice Problems (Solutions)

Problem 1:

 

Problem 2:

 

 

 

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Introduction to Financial Analysis Copyright © 2022 by Kenneth S. Bigel is licensed under a Creative Commons Attribution 4.0 International License, except where otherwise noted.

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