The dividend growth model is used by many investors to value stock. Calculate the price of a share of Megaware stock today by using the following dividend growth model equation:
P0 = E1(1 - b) / Rs = ROE × b
The value of the stock equals next year's dividends divided by the sustainable growth rate
- The dividend-payout ratio is 1 minus b, where b is the retention ratio. The dividend next year (P0) will be the earnings next year (E1) times 1 minus the retention ratio: P0 = E1(1 - b).
- The sustainable growth rate (Rs) is the return on equity (ROE) times the retention ratio: Rs = ROE × b.
Based on your results, should Megaware pay a dividend or expand its manufacturing capability? Explain your decision.