Question

Consider a company, which stock is currently trading at €8.00. The company has just paid a dividend of €0.30 per share. You expect the dividend to increase by 10% for the next two years and then increase by 5% per year forever. Suppose that your required return in case of this company is 8%. Estimate the value of this company’s stock by using a two-stage Dividend Discount Model and judge whether this company’s stock is undervalued, fairly valued, or overvalued.

Answer 1

g1 = growth rate = 10%

g2 = growth raet = 5%

r = required return = 8%

D0 = Current Dividend = €0.30

D1 = Dividend in Year 1 = D0 * (1+g1) = €0.30 * (1+10%) = €0.33

D2 = Dividend in Year 2 = D1 * (1+g1) = €0.33 * (1+10%) = €0.363

D3 = Dividend in Year 3 = D2 * (1+g2) = €0.363 * (1+5%) = €0.38115

Horizon Value = D3 / (r - g)

= €0.38115 / (8%-5%)

= €12.705

Expected Stock Price today = [D1 / (1+r)^1] + [D2 / (1+r)^2] + [Horizon Value / (1+r)^2]

= [€0.33 / (1+8%)^1] + [€0.363 / (1+8%)^2] + [€12.705 /(1+8%)^2]

= [€0.33 / 1.08] + [€0.363 / 1.1664] + [€12.705 / 1.1664]

= €0.3055555556 + €0.311213992 + €10.8924897

= €11.5092592

Therefore, Expected stock price today is €11.51

Current Stock Price is €8.00

The stock is under valued because expected stock price is more than Current stock price.