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West Texas Communications Inc. just paid a dividend of $2.16. The dividend is expected to grow...

West Texas Communications Inc. just paid a dividend of $2.16. The dividend is expected to grow at a rate of 3.5%. If your required rate of return on the stock is 8.0% and the stock is currently priced at $49.20, should you buy or sell?

  • You should buy it: it is overvalued by $0.48.
  • You should buy it: it is undervalued by $0.48.
  • You should sell it: it is undervalued by $1.20.
  • You should sell it: it is overvalued by $1.20.
  • You should sell it: it is overvalued by $0.48.
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Answer #1

You should buy it: it is undervalued by $0.48.

As per dividend discount model,
Current stock price = D0*(1+g)/(Ke-g) Where,
= 2.16*(1+0.035)/(0.08-0.035) D0 = Last paid dividend
= $    49.68 g = Growth rate
Ke = Discount rate
Stock is currently priced at $ 49.20.
Undervaluation of stock = Fair Price - Current selling price
= $    49.68 - $    49.20
= $       0.48
So,Stock is undervalued by $ 0.48 and it should be bought.
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