Question

IBM just paid a dividend of $1.2 per share. You expect IBM's dividend to grow at a rate of 10% per year for the next three years, and then you expect constant dividend growth of 5% forever. Based on the risk of IBM stock, you require a return of 8%. Using the dividend discount model, what is the value of IBM stock?

Answer 1

Step-1, Dividend per share for the first 3 years

Dividend in Year 1 (D1) = $1.32 per share [$1.20 x 110%]

Dividend in Year 2 (D2) = $1.45 per share [$1.32 x 120%]

Dividend in Year 3 (D3) = $1.60 per share [$1.45 x 120%]

Step-2, Calculation of Stock Price in Year 3 (P3)

Stock Price in Year 3 = D3(1 + g) / (Ke – g)

= $1.60(1 + 0.05) / (0.08 – 0.05)

= $1.68 / 0.03

= $55.90 per share

Step-3, The Value of the stock

The Current Price of the stock is the aggregate of present value of the 3 year dividends plus stock price in year 3

Price of the Stock = D1/(1 + Ke)¹ + D2/(1 + Ke)² + D3/(1 + Ke)³ + P2/(1 + Ke)³

= $1.32/(1 + 0.08)¹ + $1.45/(1 + 0.08)² + $1.60/(1 + 0.08)³ + $55.90/(1 + 0.08)³

= [$1.32 / 1.08] + [$1.45 / 1.1664] + [$1.60 / 1.2597] + [$55.90 / 1.2597]

= $1.22 + $1.24 + $1.27 + $44.38

= $48.11 per share

“Therefore, the value of IBM stock would be $48.11 per share”