Question

Nonconstant Growth Stock Valuation Assume that the average firm in your company's industry is expected to grow at a constant rate of 4% and that its dividend yield is 8%. Your company is about as risky as the average firm in the industry and just paid a dividend (D0) of $3. You expect that the growth rate of dividends will be 50% during the first year (g0,1 = 50%) and and 25% during the second year (g1,2 = 25%). What is the required rate of return on your company’s stock? What is the estimated value per share of your firm’s stock?

Answer 1

What is the required rate of return on your company’s stock?

The required rate of return, Ke = Dividend yield + Long term growth rate = 8% + 4% = 12%

What is the estimated value per share of your firm’s stock?

D₀ = $ 3

g_0,1 = 50%; g_1,2 = 25% and g= 4% thereafter

D₁ = D₀ x (1 + g_0,1) = $ 3 x (1 + 50%) = $ 4.50

D₂ = D₁ x (1 + g_1,2) = $ 4.50 x (1 + 25%) = $ 5.625

D₃ = D₂ x (1 + g) = $ 5.625 x (1 + 4%) = $ 5.85

Horizon value of future dividends at the end of year 2 = HV_year2 = D₃ / (Ke - g) = 5.85 / (12% - 4%) = $ 73.125

Value per share = PV of all future dividends + PV of horizon value

=$ 66.80