Q5. Valuation Models (25 marks) At year-end 2017, the City of London expected BP's ple's dividends would grow at 5% for 3 years, after which growth would fall to a long-term rate of 2%. Analysts also projected a required rate of return of 6% for the UK equity market and the UK T-Bill rate would be 2.0% and BP had a beta of 0.85. The following financial data for BP and the FTSE100 index are given: BP plc Selected Financial Data Year Ending December 31, 2017 Earnings per share 0.40 Dividends per share 0.16 Other Data on BP Common shares outstanding (M) 6000 Closing share price 1.80 FTSE 100 Index Closing value (price) 7500 17.90 P/E ratio (average) (a) As an equity analyst, suppose that you decide to use the following two-stage dividend growth model: PD D D D (k-g) + + + (1+k) (1+k) (1+k) (1+k) Explain the logic behind the above equation to calculate BP's share price. Using the data in the table and the above formula calculate the implied fair price of BP shares using the dividend growth model. (10 marks) (b) Explain the advantages of using a two-stage dividend discount model (DDM) to value a share rather than a constant-growth dividend model. Using a simple numerical example, describe one weakness in all DDMs. (5 marks) (c) Define the price-earnings (P/E) ratio. Using the data in the table above, calculate BP's historic price-earnings ratio and the price-earnings ratio relative to the FTSE 100 index as of December 31, 2017. (3 marks) (d) The Prospective P/E ratio uses next year's (forecasted) earnings, E1: Po/E1 [di /E1]/(k-g) For 2018, assume the payout ratio is the same as 2017 and that k is as given in part (a). If the analyst expects earnings per share to grow by 6% in 2018, calculate the prospective P/E ratio for BP. (5 marks) (e) State one advantage and one disadvantage of both the dividend valuation and the price-earnings valuation methods used to value Tesco shares. (2 marks)