Question

Bob and Lois Whiston are a middle-aged couple who would like to add an equity investment to their portfolio. They require a 12% rate of return and are considering the purchase of one of the following two common stocks: Stock 1: dividends currently are $1.50 annually and are expected to increase 8% annually; market price = $35 Stock 2: dividends currently are $2.25 annually and are expected to increase 7% annually; market price = $50 Which stock would be more appropriate for the Whistons to purchase at this time, using the dividend valuation model?

Answer 1

By Dividend valuation model, P = D/(r-g) where

D = Annual Dividend

r = Required rate of return

g = Dividend growth rate

Consider

Stock 1: D = $1.5, r = 12%, g = 8%

According to dividend valuation model,

Given market price is $35, we can say that it is underpriced (i.e., cheaper) by $2.5

Stock 2: D = $2.25, r = 12%, g = 7%

Given market price is $50, we can say that it is overpriced(i.e. expensive) by $5.

Conclusion: Hence Stock 1 is appropriate because it is valued $2.5 lower by the market.