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The Dividend Discount Model: It’S Reliability on the Valuation of Common Stock at the Nairobi Stock Exchange

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The Dividend Discount Model: It’S Reliability on the Valuation of Common Stock at the Nairobi Stock Exchange THE DIVIDEND DISCOUNT MODEL: IT’S RELIABILITY ON THE VALUATION OF COMMON STOCK AT THE NAIROBI STOCK EXCHANGE BY OMONDI, TOBIAS OLWENY A MANAGEMENT RESEARCH PROJECT SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTERS IN BUSINESS ADMINISTRATION, FACULTY OF COMMERCE, UNIVERSITY OF NAIROBI. AUGUST 2003 DECLARATION This management Research Project is my original work and has not been presented for a degree in any other university. OMONDI, T.O (D/61/7100/01) Signed: -----------------------Datc: This Management Research Project has been submitted for examination with my approval as University Supervisor. Supervisor: Signed : D a c . a L /- 2-00.3 . M.M.M’MAITHULIA Lecturer, Department o f Accounting Faculty of Commerce University of Nairobi DEDICATION To my grandparents, the late Rev. Wilson Muma Okwaro and Mrs. Grace Munia, for their inspiring support throughout my academic life. May the almighty God bless them. ACKNOWLEDGEMENTS I would like to give special thanks to the following people, who contributed to the successful completion of this project and my studies. First, my supervisor Mr.M’Maithulia for his guidance, devotion, positive criticisms and suggestions throughout the research period.Mr.M.N. Anyangu, Chairman, Department of Accounting, for encouragement during the conceptualization stage of the project and all my lecturers in the MBA Program who took me through the courses. Finally, all my colleagues in the program especially Kelly Mart, for their encouragement in one way or the other. TABLE OF CONTENTS Page List of Tables......................................................................................................................... vi List of Appendices.................................................................................................................vii A bstract.................................................................................................................................... viii CHAPTER ONE IN T R O D U C T IO N ............................................................................................................ 1 1.1 Background.............................................................................................................. 1 1.2 Statement of the Problem...................................................................................... 15 1.3 Objectives of the Study........................................................................................... 16 1.4 Importance of the Study......................................................................................... 16 CHAPTER TWO LITERATURE REVIEW ................................................................................................... 18 2.1 Approaches to Valuation....................................................................................... 18 2.2 Effects of Dividends on Share Prices................................................................20 2.3 Valuation of New Issues....................................................................................... 26 CHAPTER THREE RESEARCH METHODOLOGY....................................................................................28 3.1 Population.................................................................................... 28 3.2 Sampling P lan........................................................................................................... 28 3.3 Data Collection.......................................................................................................... 29 3.4 Data Analysis............................................................................................................. 30 CHAPTER FOUR DATA ANALYSIS AND FINDINGS..............................................................................37 4.1 Introduction...............................................................................................................37 4.2 The Market Model................................................................................................... 37 4.3 The Dividend Discount M odel..............................................................................42 CHAPTER FIVE CONCLUSIONS, LIMITATIONS AND SUGGESTIONS FOR FURTHER RESEARCH...........................................................................................................................50 5.1 Conclusions.................................................................................................................50 5.2 Limitations of the Study......................................................................................... 50 5.3 Suggestions for Further Research....................................................................... 52 APPENDICES....................................................................................................................... 53 REFERENCES LIST OF TABLES Table Page 1 Market Model derived for each company.................................................................................38 2 Predicted share prices using the market model.....................................................................39 3 An analysis of the differences between the actual and predicted prices by the market model................................................................................................................. 41 4 The required rates o f return computed for each company..................................................46 5 Predicted prices using the dividend discount model........................................................... 47 6 An analysis o f the differences between the actual and the predicted prices by the dividend discount model............................................................................................ 49 vi LIST OF APPENDICES Appendix page A. Companies studied....................................................................................................... 53 B. Monthly returns for the market and sampled companies.....................................54 C. A reproduction o f the computer printouts for the market model........................60 D. A reproduction o f the computer printouts for the Ms-excel analysis for the differences between actual and predicted prices using the dividend discount m od el..........................................................................70 E. A reproduction of the computer printouts for the Ms-excel analysis for the differences between the actual and predicted prices using the dividend discount model..........................................................................74 vn ABSTRACT Valuation of common stock is very important yet a very complex process. The stock requires a deeper analysis compared to preferred stock or debts. The major techniques o f valuation of common stock are: (i) Relative valuation models which is based on the earnings power of the firm, the book value and sales. (ii) The discounted cash flow techniques, where the value of stock is estimated based upon the present value of some measure of cash flow including dividends, operating cash flow among others. The study was conducted to establish the reliability of the dividend discount model (which is based on the discounted cash flow techniques) on the valuation of common stock at the Nairobi Stock Exchange. Data was collected in form o f share prices, market indices and dividend per share from the Nairobi Stock Exchange secretariat, and were used to predict share prices for each of the eighteen companies studied. Market model was used as a model of equilibrium to provide a link between the expected values which are non observable and real values that were used in testing the model. Predicted share prices were compared with the actual prices by computing the differences between them. The differences were then subjected to t-test. The test of significance showed that out of the eighteen companies studied; only three showed that the differences were significant. I therefore concluded that the dividend discount model is not reliable in the valuation of common stock at the Nairobi Stock Exchange. vm CHAPTER ONE INTRODUCTION H Background The investment process involves decisions by an investor on what marketable securities to invest in, the extent of the investment and when the investment should be made. The investment environment includes the kinds of marketable securities that exist, where and how they are bought or sold. Investment is a commitment o f funds for a certain period o f time in order to derive a rate of return to compensate for the time funds are invested, the expected rate o f inflation during that time, the liquidity premium and the risk involved. When an investor commits certain funds, he expects a stream o f returns over the period o f ownership. The investor could be an individual, a government, a pension fund or a corporation. The investor therefore trades a known shilling amount today for some expected future stream o f payments that will be greater than the current outlay (Reilly and Brown 2000). Since an investment involves sacrifice o f a current shilling for a future shilling, time and risk must be taken into consideration. The sacrifice made today is certain while the returns expected in future are uncertain. Discounted cash flow formulas take into account the risk on the value o f an investment; hence the value can be determined as follows: 1 v„ = c , + C2 + + C, + Cn (1) (1+k,)1 (l+k2 Y (l+k,)‘ (l+kn)n V0 = the current or present value o f an investment. Ct = expected returns at time t. k, =
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