Question

Suppose you bought today one share of XYZ Company, a fairly priced stock, that just paid $0.27 of dividend per share. Assume the dividend is expected to grow at a constant rate of 5% starting next year and the stock price is expected to be $52.50 at the end of next year. What would be your rate of return on this investment?

Answer 1

As per Dividend Discount Model:

Stock price = Expected dividend/ (Rate of return – Constant growth in dividend)

$ 52.50 = $ 0.27 x (1.05)2 / (Rate of return – 0.05)

          = $ 0.27 x 1.1025/ (Rate of return – 0.05)

          = $ 0.297675/ (Rate of return – 0.05)

Rate of return – 0.05 = $ 0.297675/$ 52.50

Rate of return – 0.05 = 0.00567

Rate of return = 0.00567 + 0.05 = 0.05567 or 5.57 %