Question

Your task is to find the value of a company stock. You have the following information:

a) Investors expect 10 EUR dividend next week. Buying stock today entitles you to receive that dividend

b) Dividends are expected to stay constant for the next three years.

c) However, dividends are expected to start growing 3% a year starting from year 4.

d) Expected return from investments with comparable risk is 13%.

Question:

1. Based on information above, what is the fundamentally justified price of a stock?

2. You observe that the current market price is 95 EUR. What should be your investment strategy given your calculations above. Even if you were not able to estimate the price, you can still describe your course of action

Answer 1

Dividend for Next week or current year and 1 to 3 years is 10 Euro

D0 will also be recived by you =10

So D1, D2, D3 = 10

then growth rate (g) =3%

D4 = D3*(1+g)

=10*(1+3%) =10.30

required return (ke)=13%

Price of stock in year 3 or P3 = D4/(ke-g)

=10.3/(13%-3%)

=103

Current price of stock (P0) is present value of dividend received and price of stock received in year 3

Price of stock (P0) = D0 + (D1/(1+ke)^1) + (D2/(1+ke)^2) +( (D3+P3)/(1+ke)^3)

= 10 + (10/(1+13%)^1) + (10/(1+13%)^2) +((10+103)/(1+13%)^3)

=104.9956927

Price of stock today (including dividend 10 Euro is 105.00 Euro

Ex-dividend price is 104.9956927-10 =95.00 Euros

B.

Current stock price is 95 Euros which is inclusive of Current dividend to be received. As our intrisic value of stock is 105 Euro. It is undervalued. So we should buy the stock as it is underpriced stock