The DDM and PEG Methods of Equity Valuation - Assignment Example

The paper "The Dividend Discount Model and PEG Methods" is a good example of an assignment on finance and accounting. Required: i. Test the assumptions of the DDM by using Johnson & Johnson vs. Shoppers Drugmart a. Calculate the risk premium of each company in the pair. (5 marks) • Use the estimated 5 year future EPS growth rate, not the dividend growth rate. • Use the annual dividend which is calculated by adding up the dividends paid in the last 4 quarters. (Note: Apple has only paid 2 quarters of dividends; annualize the 2 payments) Solution Whilst using the estimated 5 year future EPS growth rate, calculations of the risk premium will be obtained from the following steps: Step1: Estimating the Expected Total Return on Stocks: Expected return on stock (%), k = Earnings per share, E / Stock Price, P Johnson, and Johnson But, P/E of Johnson and Johnson is 22.

70; Therefore, k, which is E/P is the reciprocal of P/E = 13.4023, is 7.46% This is also obtained from the above formula, k = EPS/P = 5.17 / 69.29 = 7.46% Shoppers Drugmart Using the above formula, the k for Shoppers Drug Mart = 6.96% Step 2: Calculating/finding the risk free rate Johnson and Johnson The risk-free rate for US Treasury Bond = 3.40% Shoppers Drug Mart The risk-free rate for UK Treasury Bond = 4.55% Step 3: Equity risk premium The equity risk premium = Rf + beta (Expected rate – Rf) For Johnson and Johnson = 3.4 + 0.52 (7.

46 – 3.4) = 5.5112% And for Shoppers Drug Mart = 4.55 + 0.35(6.96 – 4.55) = 5.3935% b. Is the risk premium what you would expect, given what you know about the respective industries in which the companies operate? Explain your answer. (5 marks) Yes, the risk premium is what I would expect given the known aspects of the pharmaceutical industry. Since 1990 when the risk premium was 8.7%, the industry has seen a significant drop in the risk premium. Therefore, I expected that the risk premium would be around the figure of 5%.

What’s more, the two firms have risk premiums that are very close to each other hence the confirmation on the risk premium. c. Do you conclude from the comparison of the risk premium for each company in the pair that the DDM has been applied in some form to arrive at the market price? Explain your answers.