Question

The following is the information related to two stocks A and B. Please give your decision whether to invest in them or not if your required rate of return (cost of equity of the firm) is 15%. (Use Gordon's Model)

Stock	EPS today	Dividend Payout	ROE	MPS
A	50	50%	10%	280
B	30	50%	20%	280

Answer 1

Stock A

Growth Rate = Retention Ratio * ROE

= 50% * 10%

= 5%

D0 = EPS * Dividend Ratio

= 50 * 50%

= 25

Valu e of Stock A =

=

= 26.25 / 0.10

= $ 262.5

Stock B

Growth Rate = Retention Ratio * ROE

= 50% * 20%

= 10%

D0 = EPS * Dividend Ratio

= 30 * 50%

= 15

Valu e of Stock A =

=

= 16.5 / 0.05

= $ 330

Stock A is overvalued in Market. It should not be purchased while Stock B is undervalued, it should be Purchased.