The consistent use of real or nominal figures in the calculation of share prices has an enormous effect on the valuation.

Question

Quizplus · Accepted Answer

When implementing the DDM it is important to distinguish between real and nominal figures.The investor can work in either real or nominal terms,and obtain the same valuation as long as all terms are expressed consistently.In the case of the DDM with assumed constant growth,there are three terms for which estimates are required: the current dividend,the constant growth rate and the cost of equity capital.As the current dividend is measured at the current point in time,it is a figure that is simultaneously both real and nominal.However,the growth rate and cost of equity capital are forward-looking estimates,and hence are subject to the influence of inflation.If the growth rate incorporates inflationary expectations,then the cost of equity capital must also be expressed as a nominal figure.Conversely,if the growth rate is expressed in real terms,then the cost of equity capital must also be expressed in real terms.The use of formal models,such as the CAPM,to estimate the cost of equity capital typically involves the use of historical data to estimate such variables as the risk-free rate of return and market risk premium.Historical data are typically available in nominal terms,and consequently,estimates of the cost of equity capital are typically nominal estimates.Therefore,it is common to work in nominal terms.

The Consistent Use of Real or Nominal Figures in the Calculation