Question

A company currently pays a dividend of $1 per share (D₀ = $1). It is estimated that the company's dividend will grow at a rate of 22% per year for the next 2 years, and then at a constant rate of 7% thereafter. The company's stock has a beta of 1.6, the risk-free rate is 10%, and the market risk premium is 7%. What is your estimate of the stock's current price?

Answer 1

Current Stock Price(Po) = $7.635

Calculation as follows :-

Step 1 - Calculate Re by using CAPM -

Re = RF + market risk premium (beta)

Re = 10 + 7(1.6) = 21.2%

Step 2 - Calculate Dividend when Growth rate will become constant ( year 3 in this case )

D1 = $1 x 1.22 = $1.22

D2 = $1.22 x 1.22 = $1.4884

D3 = $1.4884 x 1.07 = $1.592588

Step 3 - Calculate Price at t= 3 ( i.e when Growth rate became constant )

P2 = D3 / Re - g

P2 = $1.592588 / ( 0.212 - 0.07 ) Note - Take g in this formula of constant growth ( 7% in this case )

P2 = $11.2154

Step 4 - Calculate PV of the Price calculated in step 3 to get Current Stock Price :-

Pull $11.2154 two years back by using discount rate 21.2% to get the Current Stock Price(Po) :-

Po = $11.2154 / (1.212)2

Po = $7.635