Question

A stock is expected to pay a dividend of $3.50 in one year.  Thereafter, the dividend is expected to grow at a constant 5% rate.  Investors demand a return of 12%.

a) What should the price of the stock be?  Show your work.

b) If the stock price is $35, is the stock overvalued or undervalued?  Should you buy the stock?

. The dividend discount model, is a reasonable model for mature companies in slow-growing industries.  But it may not be a good model for a young company in a fast-growing industry.  Why not?

Answer 1

a) The stock price as per the Constant Gordon Growth Model is :

Po = D1/ Re - g

= $3.5 / 0.12 - 0.05

= $50

b) If the stock price is $35, then we should buy this stock as this stock is undervalued. So, if this stock is under Valued we should buy this stock. As per the model, the stock price should be $50, but as the stock price is $35, the stock is undervalued.

c) The dividend discount model assumes that the growth rate is constant. Generally the mature companies have a constant growth rate as they have already exhausted the growth capacity. So, the constant growth model is apt for the valuations of these companies. It is may not be a good model for fast growing industries as the growth rate of these companies might not be stable rate and sometimes the growth rate can also be negative and the growth rate is always fluctuating. In this case, the constant growth model cannot be used.