Question

The share of a certain stock paid a dividend of Rs. 2 last year. The dividend is expected to grow at a constant rate of 7 percent in the future. The required rate of return on this stock is considered to be 14 %. How much should this stock sell for now assuming that the expected growth rate and required rate of return remain the same. At what price should the stock sell 4 years hence ?

Answer 1

The price of the Stock can be calculated by using the Gordon Growth Model

The formula for calculating the stock price is

P = D1 / ( r - g )

where P = Price of the Stock

D1 = Dividend expected in the next year

r = required rate of return

g = constant dividend growth rate

A) Stock price now

D1 = 2 * 1.07 = 2.14

r = 14% = 0.14

g = 7% = 0.07

P = 2.14 / ( 0.14 - 0.07 )

= 2.14 / 0.07

= $ 30.57

Therefore the expect stock price now as per Gordon Growth Model is $ 30.57

B) Stock price 4 years from now

D5 = 2 * (1.07^5)

= 2 * 1.4025

= 2.805

r = 14% = 0.14

g = 7% = 0.07

P = D5 / ( r - g )

P = 2.80 / (0.14 - 0.07 )

= 2.805 / 0.07

= $ 40.07

Therefore the expect stock price 4 years from now as per Gordon Growth Model is $ 40.07