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?

2. The dividend discount model, as employed in problem 1, 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

D1: dividend expected in 1-year = 3.5

g: growth rate = 5%

Ke: cost of equity = 12%

P: price of stock

(a) P = D1/(Ke-g) = 3.5/(12%-5%) = $50

(b) Since the stock price $35<$50, the stock is undervalued

2) This is because mature companies have a stable growth rate & relativley constant dividend payout ratio. Therefore 1 stage dividend disount model as applied above is applicable

A young company in a fast-growing industry, the dividend growth rates and dividend payout ratios will be different in different phases of the company. Therefore we will have to apply a two stage/three stage or H-model to value the stock based on dividend discount model