Question

Your thinking about investing $100,000 into one of two stocks. Both stocks are in the same industry sector and are priced at the same market capitalization rate of 12%. Stock A is expected to pay out a $1.25 annual dividend and that dividend is not expected to grow. Stock B is expected to pay out an annual dividend of $2.45. Stock B retains some of its earnings and reinvests at a good ROE.

Assuming that the two stocks are correctly priced, which is the better investment?

Answer 1

Price of a stock, P = Expected dividend / (Capitalization rate - growth in earnings)

In case of stock A, dividend is not expected to grow. Hence, the growth = 0. Hence, P = Expected dividend / Capitalization rate and is expected to remain constant throughout.

In case of stock B, there will be a sustainable growth rate, g = Retention ratio x ROE

This growth rate will translate into growth in earnings which will translate into growth in dividends and hence P will grow every year from now onward. Hence, the investment has a potential to grow in case of stock B.

Hence, stock B is a better investment.