Question

A share last year paid a dividend of $3, the company is expected to have a constant rate of growth of dividends of 4%. The required rate of return is 12% what according to the Gordon constant growth model is a fair price for the share? What would be the fair price for the share of the forecast growth rate of dividends was to be raised to 9%?

Answer 1

According to the Gordon constant growth model, fair price of share is calculated as present value of all future dividends discounted using required rate of return for the company. Here company pays dividends that is expected to grow every year at a fixed rate i.e., the growth rate remains constant here.

Fair price of a share is calculated as,

P = D1 / r - g

where,

P means ,Intrinsic value / Fair price / Current price

D1 means Next year divident which is calculated as

D0 ( 1 + g )

here D0 means Divident paid last year

r means Required rate of return for the company

g means Expected growth rate

Fair value if growth rate is 4%,

P = D1 / r - g

P = D0 ( 1 + g ) / r - g

P = 3 (1 + .04 ) / (.12 - .04)

= $ 39

Fair value if growth rate is 9%,

P = D1 / r - g

P = D0 ( 1 + g ) / r - g

P = 3 (1 + .09 ) / (.12 - .09)

= $ 109