Question

Two stocks both trade for $22 per share. Stock A pays a constant dividend of $1...

Two stocks both trade for $22 per share. Stock A pays a constant dividend of $1 per year and is expected to have no growth in dividends. Stock B pays an annual dividend of $0.50 per share but also has $12/share in present value of growth opportunities. If the appropriate discount rate on Stock A is 5% and Stock B is 8%, which of these stocks (if either) is the MOST undervalued?

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Answer #1

Using constant dividend model

Fair price of stock A =  constant dividend /discount rate

= 1/.05

= $20

Stock A trade for $22/share, its fair price is only $20/share. Hence, it is overvalued.

present value of growth opportunities = Stock price - (Earnings/discount rate)

12 = Stock price - (.50/.08)

= Stock price -6.25

Stock price = 12+6.25

= $18.25

Stock B trade for $22/share, its fair price is only $18.25/share. Hence, it is overvalued.

Answer: Both are overvalued.

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