The value of an equity share is a function of cash inflows expected by the investors and the risk associated with the cash inflows. It is calculated by discounting the future stream of dividends at the required rate of return, called the capitalisation rate. The required rate of return depends upon the element of risk associated with investment in shares. It will be equal to the risk-free rate of interest plus the premium for risk.
Thus, the required rate of return, Ke, for a share is,
Ke = Risk-free Rate of Interest + Premium for Risk
Further, if the dividends of a firm are expected to grow at a constant rate forever and the market is in equilibrium, there should be no difference between the present value and the market price of the share.
In such a situation, the required rate of return can be calculated with the following equation:
P0 = D1/Ke – g
or, Ke = D1/P0 + g
where, P0 = Current price of the share
Ke = Required rate of return
D1 = Expected dividend in year 1
g = Rate of growth
Sometimes, we may be required to calculate the rate of return which an investor can expect if he purchases an equity share at the current market price (P0) hold it for one year and then sell the same at the market price prevailing at the end of one year (P1).
The expected rate of return, re, caa be calculated with the following formula:
P0 = D1 + P1/(1+re)
or, re = D1/P0 + P1 – P0/P0
In case, the investor wants to hold the share for a very long period, say infinity and the dividends are expected to grow at a compound annual rate, the expected rate of return re, can be calculated as:
re = D1/P0 + g
Illustration 1:
The equity share of a company is currently selling at Rs. 80. It is expected that the company will pay a dividend of Rs. 4 at the end of one year and the share can be sold at a price of Rs. 88. Calculate the return on share. Should an investor buy it, if his capitalisation rate is 12 percent?
Solution:
re = D1/P0 + P1 – P0/P0
= 4/80 + 88 – 80/80
= 0.05 + 0.10
= 0.15 or 15%
The investor should buy the share as expected return on share (15%) is higher than the capitalisation rate of 10%.
Illustration 2:
The current price of a company’s share is Rs. 60. The company is expected to pay a dividend of Rs. 4.80 per share at the end of one year. The dividends are expected to grow perpetually at a rate of 6 percent. If an investor’s required rate of return is 15 percent, should he buy the share?
Solution:
re = D1/P0 + g
= 4.80/60 + 0.06
= 0.08 + 0.06
= 0.14 or 14%
As the expected rate of return, 14% is less than the 15% required rate of return, the share should not be bought.