Question

You expect a share of stock to pay dividends of $1.00, $1.25, and $1.50 in each of the next 3 years You expect a share of stock to pay dividend of $1.00, $1.25 and $1.50 in each of the next three years. After three years, its dividend will grow at a constant rate of 3% per year. Assume the cost of capital of the company is 12%, what would be a reasonable estimate of the stock price based on dividend discount model?

Answer 1

Given about a stock,

stock is expected to pay dividend of $1.00, $1.25 and $1.50 in each of the next three years.

So, D1 = $1.00

D2 = $1.25

D3 = $1.50

thereafter, dividends are expected to grow at a constant rate of 3% per year

So, growth rate g = 3%

Cost of capital Kc = 12%

So, stock price at year 3 using constant dividend growth rate is

P3 = D3*(1+g)/(Kc - g) = 1.5*1.03/(0.12-0.03) = $17.1667

expected stock price today is sum of PV of all dividends and stock price at year 3

So, P0 = D1/(1+Kc) + D2/(1+Kc)^2 + D3/(1+Kc)^3 + P3/(1+Kc)^3

P0 = 1/1.12 + 1.25/1.12^2 + 1.5/1.12^3 + 17.1667/1.12^3 = $15.18

reasonable estimate of the stock price based on dividend discount model is $15.18