Question

2. A stock is currently selling for $50, pays a dividend of $2.00. Dividends are expected to grow at a constant rate of 3% a year. Investors require an 8% rate of return.

a. Calculate the intrinsic value (estimated price) for this stock.

b. If an analyst uses a 10% rule

i. At what price range would this stock be considered to be overvalued?

ii. At what price range would this stock be considered to be undervalued?

iii. At what price range would this stock be considered to be fairly priced?

iv. Is this stock overvalued, undervalued, or fairly priced?

v. What is the purpose of employing a 10% rule in this valuation process?

Answer 1

Qa:

Intrinsic value of stock=stock price= D*(1+g)/(k-g)

where D=dividend; g=growth rate; k=required return

Expected stock price=2*(1+3%)/(.08-.03)=41.2 $

Qb: According to 10% rule

i: if price is above 41.2*(1+10%) =45.32 $ ; ie:Market Price>45.32 $ ; Over valued

ii: if price is below 41.2*(1-10%) =37.08 $ ; ie Market price<37.08$; under valued

iii: if price is between 37.08 and 45.32 ; fairly priced

iv: Current price is 50$ which is above 45.32 ; hence stock is overvalued

v: 10% rule will give a certain level of allowance for the calculation error that can comes during the valuation of stock price. It also gives the investors a confidence on their decision that can be based on such calculations.