Question

A stock is currently traded at $30 per share. It has an expected dividend to be paid at the end of the year of $2.5 per share, and an expected growth rate to infinity of 5% per year. If investors' required return for this particular stock is 12% per year, then this stock is:

		overvalued and offering an expected return higher than the required return.
		undervalued and offering an expected return higher than the required return.
		overvalued and offering an expected return lower than the required return.
		undervalued and offering an expected return lower than the required return.
		at equilibrium and offering an expected return equal to the required return.

Answer 1

Given about a stock,

Current price = $30

expected dividend next year D1 = $2.5

expected growth rate g = 5%

So, using constant dividend growth rate model, expected return on the stock is

=> E(r) = D1/P0 + g = 2.5/30 + 0.05 = 13.33%

Required return on stock = 12%

When expected return on a stock is higher than required rate of return, the stock is undervalued.

So, this stock is undervalues and offering an expected return higher than the required return.

Option B is correct.