Question

Your sister –in-law, a stockbroker at invest Inc., is trying to sell you a stock with a current market price of $25. The stock’s last dividend (D0) was $2.00, and earnings and dividends are expected to increase at a constant growth rate of 10%. Your required rate on this stock is 20%. From a strict valuation standpoint, you should a. Buy the stock; it is fairly valued. b. Buy the stock; it is undervalued by $3.00. c. Buy the stock; it is undervalued by $2.00. d. Not buy the stock; it is overvalued by $2.00. e. Not buy the stock; it is overvalued by $3.00.

Answer 1

Ans.

According to Constant Growth model,

P0= D0(1+g)/Re - g

Where,

• P0 is the price of stock
• D0 * (1+g) is the D1 i.e. expected dividend for the next period
• Re is the required rate of return
• g is the growth rate

P0 = $ 2 (1.10) /0.20 -0.10 = $22

Current market price = $25 (given)

As the current market price ($25) is more than the fair price( $22), the stock is overvalued by $ 3 and should not be purchased.

So the correct option is e.

Not buy the stock; it is overvalued by $3.00.