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Share Valuation Models- Part 1

BY: Vivek SHARMA | Category: Others | Submitted: 2010-12-24 10:44:11
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Article Summary: "This article provides details of Walter model used for valuation of a company's share..."

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There are lots of literatures available on how to value the share of a company. These models are based on different assumptions are value the share of a company based on specific assumptions. One of these models is known as ,'Walter Model'. James Walter who had proposed the valuation of share based on the dividend policy of the company.

The Walter model is based on the following assumption:

1) The firm is an all equity financed entity. This means that debt has no role to play in the financing of a company. Infosys can be an ideal example of such company which is fully financed through equity
2) The rate of return on investments is constant.
3) The firm has an infinite life.

While the first and third assumptions sound logic, the second assumption is not valid. However, it is required to establish the authencity of the model.

Based on the above assumption, Walter put forward the following valuation formula:

D plus( E minus D) r( divided by)k

In this formula, D is dividend, E is earnings, r is rate of return on investments and k is cost of capital. E minus D denotes the retained earnings per share.

This model can be further put as :
D (E minus D)r(divided by)k

P=------ plus -------------
k k

The first component is the present value of an infinite stream of dividends and the second component is the present value of an infinite stream of returns from retained earnings.

The following conclusion can be drawn with the help of this model:

a) When r is more than k, the share price of a company increases as dividend pay out decreases
b) If r=k, there is no change in the share price if the dividend pay out ratio is changed
c) In the third scenario, if the r is less than k, the share price increases if the dividend payout is increased by a company.

This effectively means that when a firm is having a scenario of r is greater than k, it should not distribute any dividend. If r=k, then the dividend payment by a company becomes irrelevant. If ris less than k, then the firm should distribute the entire earnings as dividend. Walter model has certain limitations, but some of its key contributions cannot be ignored.

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